10-Q 1 e10-q.txt QUARTERLY REPORT FOR THE PERIOD ENDED 06-30-2000 1 -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------------------ FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2000 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ____________ TO ____________ . COMMISSION FILE NUMBER 000-29405 ------------------------ ORGANIC, INC. (Exact name of registrant as specified in its charter) DELAWARE 94-3258989 (State or other jurisdiction of (IRS Employer Identification Number) incorporation or organization) 510 THIRD STREET SAN FRANCISCO, CALIFORNIA 94107 (Address of principal executive offices) (415) 365-5500 (Registrant's telephone number, including area code) ------------------------ Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] The number of shares outstanding of the Registrant's Common Stock, par value $.0001, as of July 31, 2000 was 87,956,512. -------------------------------------------------------------------------------- -------------------------------------------------------------------------------- 2 ORGANIC, INC. FORM 10-Q QUARTERLY REPORT TABLE OF CONTENTS

PAGE ---- PART I. FINANCIAL INFORMATION Item 1. Financial Statements: Condensed Consolidated Balance Sheets as of June 30, 2000 (unaudited) and December 31, 1999........................... 1 Condensed Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2000 and 1999 (unaudited)................................................. 2 Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2000 and 1999 (unaudited)............. 3 Notes to Condensed Consolidated Financial Statements........ 4 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations................................... 8 Item 3. Quantitative and Qualitative Disclosures About Market Risk........................................................ 21 PART II. OTHER INFORMATION Item 1. Legal Proceedings........................................... 22 Item 6. Exhibits and Reports on Form 8-K............................ 22 SIGNATURES........................................................... 23

i 3 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS ORGANIC, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS

JUNE 30, DECEMBER 31, (IN THOUSANDS, EXCEPT SHARE DATA) 2000 1999 ------------------------------------------------------------ ----------- ------------ (UNAUDITED) ASSETS Current assets: Cash and cash equivalents................................. $ 89,405 $ 8,385 Accounts receivable, net of allowance of $2,822 at June 30, 2000 and $1,078 at December 31, 1999................ 24,399 18,769 Costs in excess of billings............................... 11,681 5,248 Deposits, prepaid expenses and other current assets....... 2,906 1,592 -------- -------- Total current assets............................... 128,391 33,994 Property and equipment, net............................... 21,143 10,759 Long-term investments in marketable securities............ 6,184 1,990 Deferred bank facility charge, net of accumulated amortization of $5,042 at June 30, 2000 and $2,017 at December 31, 1999....................................... 13,109 16,134 Other assets.............................................. 406 1,387 -------- -------- Total assets....................................... $169,233 $ 64,264 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable.......................................... $ 6,663 $ 3,232 Current portion of long-term debt......................... 323 13,450 Current portion of obligations under capital leases....... 35 44 Accrued expenses.......................................... 3,895 5,245 Accrued employee costs.................................... 5,361 4,206 Deferred rent............................................. 755 345 Deferred revenue.......................................... 14,958 12,152 -------- -------- Total current liabilities.......................... 31,990 38,674 Long-term debt, net of current portion.................... 219 381 Obligations under capital leases, net of current portion................................................. 85 97 -------- -------- Total liabilities.................................. 32,294 39,152 -------- -------- Minority interest in consolidated subsidiary................ 258 334 Stockholders' equity: Series A convertible preferred stock, $.0001 par value, 21,675,000 shares authorized, 0 and 21,675,000 shares issued and outstanding at June 30, 2000 and December 31, 1999, respectively (aggregate liquidation preference $64,664)................................................ -- 2 Series B convertible preferred stock, $.0001 par value, 1,488,000 shares authorized, 0 and 1,488,000 shares issued and outstanding at June 30, 2000 and December 31, 1999, respectively (aggregate liquidation preference $10,724)................................................ -- -- Common stock, $.0001 par value, 200,000,000 shares authorized, 87,977,655 and 2,844,642 shares issued and outstanding at June 30, 2000 and December 31, 1999, respectively............................................ 9 -- Additional paid-in capital................................ 291,977 151,743 Notes receivable from stockholders........................ (4,613) -- Deferred stock-based compensation......................... (66,631) (83,370) Accumulated deficit....................................... (87,893) (43,607) Accumulated other comprehensive income.................... 3,832 10 -------- -------- Total stockholders' equity......................... 136,681 24,778 -------- -------- Total liabilities and stockholders' equity......... $169,233 $ 64,264 ======== ========

The accompanying notes are an integral part of these condensed consolidated financial statements. 1 4 ORGANIC, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, ------------------------ ---------------------- (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) 2000 1999 2000 1999 ----------------------------------------------- ----------- ---------- ----------- -------- Revenues..................................... $ 37,161 $ 17,267 $ 66,375 $ 27,354 Operating expenses: Professional services (exclusive of stock-based compensation reported below of $4,106 and $800 for the three months ended June 30, 2000 and 1999, and $13,950 and $1,101 for the six months ended June 30, 2000 and 1999, respectively)............ 18,156 8,263 34,492 13,831 Selling, general and administrative (exclusive of stock-based compensation reported below of $6,471 and $1,376 for the three months ended June 30, 2000 and 1999, and $21,022 and $1,798 for the six months ended June 30, 2000 and 1999, respectively)........................... 22,232 8,325 42,142 12,974 Stock compensation and other stock-based charges................................. 10,577 2,176 34,972 2,899 ----------- ---------- ----------- -------- Total operating expenses........... 50,965 18,764 111,606 29,704 ----------- ---------- ----------- -------- Operating loss............................... (13,804) (1,497) (45,231) (2,350) Minority interest in operations of consolidated subsidiary................................. 21 4 76 27 Investment loss.............................. (353) -- (353) -- Interest income, net......................... 1,288 36 1,634 15 ----------- ---------- ----------- -------- Net loss before taxes.............. (12,848) (1,457) (43,874) (2,308) Income tax expense........................... 213 23 412 38 ----------- ---------- ----------- -------- Net loss........................... $ (13,061) $ (1,480) $ (44,286) $ (2,346) =========== ========== =========== ======== Basic and diluted net loss per share......... $ (0.16) $ (1.35) $ (0.67) $ (2.35) =========== ========== =========== ======== Weighted average common shares outstanding -- basic and diluted.......................... 83,945,906 1,093,883 66,012,175 997,803 =========== ========== =========== ========

The accompanying notes are an integral part of these condensed consolidated financial statements. 2 5 ORGANIC, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

SIX MONTHS ENDED JUNE 30, ------------------- (IN THOUSANDS) 2000 1999 ------------------------------------------------------------ -------- ------- CASH FLOWS FROM OPERATING ACTIVITIES: Net loss.................................................. $(44,286) $(2,346) Adjustments to reconcile net income to net cash used in operating activities: Depreciation and amortization.......................... 4,456 1,314 Stock compensation and other stock-based charges....... 34,972 2,899 Other non-cash charges................................. 3,165 170 Changes in assets and liabilities: Increase in accounts receivable...................... (8,513) (8,966) Increase in costs in excess of billings.............. (6,433) (1,684) Increase (decrease) in accounts payable and accrued expenses............................................ 2,939 (562) Increase in deferred revenue......................... 2,806 5,478 Other assets and liabilities......................... 326 (265) -------- ------- Net cash used in operating activities............. (10,568) (3,962) -------- ------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property and equipment........................ (14,798) (2,727) Purchase of short-term investments........................ (194) (2,005) Other investing activities................................ (347) 1,089 -------- ------- Net cash used in investing activities............. (15,339) (3,643) -------- ------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from issuance of convertible preferred stock, net.................................................... -- 7,718 Proceeds from issuance of common stock, net............... 117,537 -- Proceeds from long-term debt.............................. 3,505 3,000 Payments on long-term debt................................ (16,794) (504) Other financing activities................................ 2,864 45 -------- ------- Net cash provided by financing activities......... 107,112 10,259 Effect of exchange rate changes on cash and cash equivalents...................................... (185) (25) -------- ------- Net increase in cash and cash equivalents......... 81,020 2,629 Cash and cash equivalents at beginning of period............ 8,385 1,667 -------- ------- Cash and cash equivalents at end of period.................. $ 89,405 $ 4,296 ======== ======= NONCASH INVESTING AND FINANCING ACTIVITIES: Unrealized gains on available for sale securities......... $ 4,007 $ -- ======== ======= Conversion of debt into preferred stock................... $ -- $ 3,000 ======== ======= Deferred stock-based compensation......................... $ 34,752 $18,005 ======== ======= Net issuance of common stock in exchange for notes receivable from stockholders........................... $ 4,613 $ -- ======== =======

The accompanying notes are an integral part of these condensed consolidated financial statements. 3 6 ORGANIC, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE 1 -- BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements of Organic, Inc. and subsidiaries ("the Company") have been prepared in accordance with accounting principles generally accepted in the United States ("GAAP") for interim financial reporting and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. However, they do not include all of the disclosures necessary for annual consolidated financial statements in conformity with GAAP. Accordingly, these unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 1999. The accompanying unaudited financial statements reflect all normal recurring adjustments which are, in the opinion of management, necessary for a fair presentation of results for the interim periods presented. The results of operations for the interim periods presented are not necessarily indicative of the operating results to be expected for any subsequent interim period or for the fiscal year ending December 31, 2000. On February 8, 2000, the Company's Board of Directors effected a 3-for-1 split of its outstanding shares of common stock. All share and per share information included in the accompanying financial statements have been retroactively adjusted to reflect this stock split. Certain amounts for prior periods have been reclassified to conform to current financial statement presentation. NOTE 2 -- INITIAL PUBLIC OFFERING In February 2000, the Company completed an initial public offering ("IPO") of 6,325,000 shares of its common stock (including the exercise of the underwriters' over-allotment option) at $20.00 per share. The Company sold all of the shares of common stock and realized proceeds, after deducting underwriting discounts, commissions and offering expenses, of approximately $115.8 million. Upon the closing date of the IPO, all of the convertible preferred stock outstanding prior to the IPO was converted into 69,489,000 shares of common stock. In addition, a warrant issued to Omnicom Group, Inc. was exercised for 2,249,076 shares of common stock. NOTE 3 -- NET LOSS PER SHARE The Company computes basic net loss per share by dividing net loss available to common stockholders for the period by the weighted average number of common shares outstanding during the period. Diluted net loss per share is computed by dividing net loss available to common stockholders for the period by the weighted average number of common and, when dilutive, common equivalent shares outstanding during the period. Common equivalent shares consist of common stock subject to repurchase rights, the incremental common shares issuable upon the exercise of the stock options and warrant (using the treasury stock method), and the incremental common shares issuable upon the conversion of the convertible preferred stock (using the if-converted method). 4 7 ORGANIC, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) NOTE 3 -- NET LOSS PER SHARE (CONTINUED) The following table sets forth the computation of basic and diluted net loss per share for the periods indicated:

THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, ------------------------- ------------------------- (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) 2000 1999 2000 1999 ----------------------------------------------- ----------- ---------- ----------- ---------- Numerator: Net loss attributable to common stockholders....................... $ (13,061) $ (1,480) $ (44,286) $ (2,346) =========== ========== =========== ========== Denominator: Weighted average common shares outstanding... 87,722,312 1,161,630 69,747,420 1,047,644 Less: weighted average unvested common shares subject to repurchase.............. (3,776,406) (67,747) (3,735,245) (49,841) ----------- ---------- ----------- ---------- Weighted average common shares used in computing basic and diluted net loss per share.............................. 83,945,906 1,093,883 66,012,175 997,803 =========== ========== =========== ========== Basic and diluted net loss per share.... $ (0.16) $ (1.35) $ (0.67) $ (2.35) =========== ========== =========== ==========

The following table sets forth common stock equivalents that were not included in the calculation of diluted net loss per share because to do so would be anti-dilutive for those periods presented.

THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, ------------------------ ------------------------ 2000 1999 2000 1999 ---------- ---------- ---------- ---------- Weighted average effect of common stock equivalents: Series A convertible preferred stock......................... -- 65,025,000 14,291,209 65,025,000 Series B convertible preferred stock......................... -- 4,464,000 981,099 3,773,436 Unvested common shares subject to repurchase.................... 3,776,406 67,747 3,735,245 49,841 Common stock options............. 10,267,180 7,148,430 11,301,604 7,072,009 Common stock warrants............ -- -- 494,302 --

NOTE 4 -- COMPREHENSIVE LOSS The Company has adopted Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive Income", which requires that an enterprise report and display, by major components and as a single total, the change in its net assets during the period from non-owner sources. The components of comprehensive loss were as follows:

THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, ------------------- ------------------- (IN THOUSANDS) 2000 1999 2000 1999 ------------------------------------------ -------- ------- -------- ------- Net loss.................................. $(13,061) $(1,480) $(44,286) $(2,346) Unrealized gains on available for sale securities.............................. 4,007 -- 4,007 -- Foreign currency translation adjustment... (138) (34) (185) (25) -------- ------- -------- ------- Comprehensive loss........................ $ (9,192) $(1,514) $(40,464) $(2,371) ======== ======= ======== =======

5 8 ORGANIC, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) NOTE 4 -- COMPREHENSIVE LOSS (CONTINUED) The tax effects of comprehensive loss were not considered material. The following is a summary of the components of accumulated other comprehensive income:

JUNE 30, DECEMBER 31, (IN THOUSANDS) 2000 1999 ----------------------------------------------- -------- ------------ Balance, beginning of period................... $ 10 $-- Unrealized gains on available for sale securities................................... 4,007 -- Foreign currency translation adjustment........ (185) 10 ------ --- Balance, end of period......................... $3,832 $10 ====== ===

NOTE 5 -- INVESTMENTS The Company's investments are primarily composed of common stock received from its customers in exchange for services rendered. Initially, the Company records the common stock on the consolidated balance sheet based on the estimated fair value of the services provided to the customers. When a more readily available fair value is determined, the investments are adjusted accordingly with the unrealized gains and losses reported as a component of accumulated other comprehensive income in stockholders' equity. The Company also recognizes any declines in value that are judged to be other than temporary. For the three months ended June 30, 2000, the Company recorded unrealized gains of $2.7 million and $1.3 million for HomeGrocer and Stan Lee Media, respectively, based on the fair market values of their publicly traded common stock. For the three months ended June 30, 2000, the Company recorded a non-recurring write-off for one of its investments, NextPlanetOver, which was purchased by eHobbies with no residual value to the existing shareholders. This amount has been recorded as an investment loss on the condensed consolidated statements of operations. For the three months ended June 30, 2000, the Company made an investment of $500,000 in Retail Options, LLC, a joint venture that includes Federated Department Stores, Sears, Roebuck & Co., Groupe Carrefour and St. Paul Fire & Marine Insurance Company. The alliance was created to identify, invest in, develop and distribute brands and technologies that present opportunities in both brick-and-mortar and e-commerce retailing. NOTE 6 -- DEFERRED STOCK-BASED COMPENSATION The Company recorded aggregate deferred stock-based compensation of $0 and $14.3 million for the three months ended June 30, 2000 and 1999, respectively, and $34.8 million and $18.0 million for the six months ended June 30, 2000 and 1999, respectively. These amounts have been included as a component of stockholders' equity and are being amortized by charges to operations over the vesting period of the related options, generally 4 years, consistent with the method described in Financial Accounting Standards Board Interpretation ("FIN") No. 28. The Company recognized stock compensation expense of $9.1 million and $2.2 million for the three months ended June 30, 2000 and 1999, respectively, and $32.0 million and $2.9 million for the six months ended June 30, 2000 and 1999, respectively. As of June 30, 2000, the Company had an aggregate of $66.6 million of deferred stock-based compensation remaining to be amortized. NOTE 7 -- RECENT ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities". The Statement will require the Company to recognize all derivatives on the balance sheet at fair value. The Statement requires that derivative instruments used to 6 9 ORGANIC, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (UNAUDITED) NOTE 7 -- RECENT ACCOUNTING PRONOUNCEMENTS (CONTINUED) hedge be identified specifically to assets, liabilities, unrecognized firm commitments or forecasted transactions. The gains or losses resulting from changes in the fair value of derivative instruments will either be recognized in current earnings or in other comprehensive income, depending on the use of the derivative and whether the hedging instrument is effective or ineffective when hedging changes in fair value or cash flows. This Statement, as amended by SFAS No. 137, is effective for fiscal years beginning after June 15, 2000. Although the Company has not fully assessed the implications of SFAS No. 133, management does not believe that the adoption of this Statement will have a material effect on the Company's consolidated financial position, results of operations or cash flows. In November 1999, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin ("SAB") No. 100, "Restructuring and Impairment Charges". In December 1999, the SEC issued SAB No. 101, "Revenue Recognition in Financial Statements". SAB No. 100 expresses the views of the SEC staff regarding the accounting for and disclosure of certain expenses commonly reported in connection with exit activities and business combinations, including the accrual of exit and employee termination costs and the recognition of impairment charges. SAB No. 101 expresses the views of the SEC staff in applying accounting principles generally accepted in the United States to certain revenue recognition issues. SAB No. 101, as amended by SAB No. 101B, is effective no later than the fourth quarter of fiscal years beginning after December 15, 1999. Management does not anticipate that these SABs will have a material impact on the Company's consolidated financial position, results of operations or cash flows. In March 2000, the FASB issued FIN No. 44, "Accounting for Certain Transactions Involving Stock Compensation -- an Interpretation of Accounting Principles Board ("APB") Opinion No. 25". FIN No. 44 clarifies the application of APB Opinion No. 25 regarding the definition of an employee for purposes of applying APB Opinion No. 25, the criteria for determining whether a plan qualifies as a non-compensatory plan, the accounting consequence of various modifications to the terms of a previously fixed stock option or award, and the accounting for an exchange of stock compensation awards in a business combination. This interpretation is effective July 1, 2000. Management does not anticipate that this Interpretation will have a material impact on the Company's consolidated financial position, results of operations or cash flows. NOTE 8 -- CONTINGENCIES On May 16, 2000, an individual real estate broker and former employee of a real estate brokerage company which had performed some work for the Company filed suit in United States District Court in New York City seeking recovery from the Company and others for broker's commissions he claims due. (Kades v. Organic, Inc., et al.) The complaint alleges claims for violation of the Racketeering Influenced Corrupt Organizations (RICO) Act, misrepresentation, interference with contractual relations and other causes of action and seeks compensatory and punitive damages against all defendants. The lawsuit is in its initial stages. The Company believes the complaint is without merit and intends to contest the claims vigorously. 7 10 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information in this report contains forward-looking statements that are based on management's current expectations. These forward-looking statements are subject to a number of risks and uncertainties that could cause actual results to differ significantly from those described in this report. Any statements that are not statements of historical facts may be deemed to be forward-looking statements. These forward-looking statements include statements regarding, among other things, our business strategy and operations, future expansion plans, future prospects, financial position, anticipated revenues or losses and projected costs, and objectives of management. For example, words such as "may", "will", "should", "believes", "anticipates", "intends", "estimates", "expects", "projects", "plans", "predicts", "potential", "continue", "strategy" and similar expressions are intended to identify forward-looking statements. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those discussed under the heading "Factors That May Affect Results" and the risks discussed in our Registration Statement on Form S-1 declared effective on February 9, 2000 by the Securities and Exchange Commission (File No. 333-91627) and Annual Report on Form 10-K filed May 8, 2000. OVERVIEW Since our founding in 1993 as a sole proprietorship and our incorporation in January 1995, we believe that we have been an innovator and leader in the Internet professional services industry. We focus on providing an integrated suite of services to our clients including strategic consulting and research, Web site design, software engineering and technical program management, online marketing services including media buying and management, public relations, and customer service and fulfillment consulting and transaction management. As the Internet continues to evolve, these services provide our clients with the necessary tools to effectively manage and grow their customer and business relationships. We have performed work for over 250 major offline and online companies to establish or enhance brands and have introduced several new service lines to address particular client needs. We are rapidly growing to accommodate the increasing demand for Internet professional service offerings and to better serve our existing clients in both their various domestic and international locations. We expect that our revenues will be driven primarily by the number, size and scope of our client engagements and by our professional services headcount. The number, size, and scope of our engagements have been increasing and we expect this trend to continue. We also anticipate our clients will engage us in more of our service offerings over time. For the six months ended June 30, 2000, five clients accounted for 48.3% of our revenues, with DaimlerChrysler accounting for 18.2%. Revenues from any given client will vary from period to period; however, we expect that significant concentration will continue for the foreseeable future as we execute on our strategy of developing deeper multi-service line relationships with our clients. To the extent that any significant client reduces its use of our services or terminates its relationship with us, our revenues could decline. As a result, the loss of any significant client could negatively impact our business and results of operations. A significant amount of our revenues are derived from providing professional services on a fixed-fee, retainer or time and materials basis. We generally enter into a service agreement with a client that establishes the legal and general business terms of our relationship. Our engagements vary depending on what type of services we provide and they range in duration from a few months to more than a year. Generally our client relationships span several years. Revenues from fixed-fee contracts are generally recognized as services are rendered using the percentage-of-completion method of accounting in accordance with Statement of Position 81-1, "Accounting for Performance of Construction Type and Certain Production Type Contracts", based on the percentage of costs incurred to date to total estimated project costs. We periodically evaluate the actual status of each project to ensure that the estimated cost to complete each contract remains accurate and any adjustments for estimated losses, if necessary, are made in the period in which such losses are determined. To date, such losses have not been significant. Revenues pursuant to retainer contracts are generally recognized over the life of the contract on a straight-line basis. Revenues pursuant to time and materials contracts are generally recognized as services are provided. Revenues exclude reimbursable expenses charged 8 11 to clients. During the six months ended June 30, 2000, we opened offices in Toronto and Atlanta. Our international operations collectively accounted for 10.4% and 9.7% of our total revenues for the three and six months ended June 30, 2000, respectively. As we continue to expand internationally, we expect to generate a greater percentage of our revenues outside of the United States. Our professional services expenses include the direct costs associated with our billable employees and contractors. These expenses include salaries, bonuses, benefits, vacation, travel and entertainment expenses. Professional services margins reflect revenues less professional services expenses which are incurred regardless of whether or not a billable employee's time is billed to a client. Historically our professional services expenses have increased and we expect these expenses in absolute dollars will continue to increase in the foreseeable future due to increased hiring, wage increases and inflation. Our professional services margins are affected by many factors, including the efficiency with which we utilize our employees and the continuation of our clients in retaining our services. Any significant decline in fees billed to clients or the loss of a significant client would adversely affect our professional services margins. If a client defers, modifies or cancels an engagement or chooses not to retain our services for additional phases of a project as expected, we must rapidly re-deploy professional services personnel to other engagements in order to minimize under-utilization which, in turn, would adversely affect professional services margins. Our selling, general and administrative expenses primarily consist of our investment in our corporate support services, our employee recruitment, training and retention programs, and our research and development and knowledge management initiatives. Our selling, general and administrative expenses also include the direct costs associated with employees and contractors in non-billable departments, real estate costs and other investments in our corporate support services. As we continue to leverage our investments in infrastructure in our global expansion, we expect these expenses will decrease as a percentage of revenues, but continue to increase in absolute dollars as we continue to hire additional personnel, invest in our knowledge management initiatives, and incur additional infrastructure costs. Although revenues have consistently increased from year to year, we have incurred significant investment costs in order to create a leadership position in the highly competitive market in which we operate. As a result, we have incurred significant losses since inception, and, as of June 30, 2000, had an accumulated deficit of $87.9 million, most of which relates to stock compensation and other stock-based charges. We believe our success depends on increasing our client base, hiring and retaining professionals, and continuing our global expansion. Accordingly, we expect associated headcount and infrastructure costs to continue to increase. Including the effects of stock compensation and other stock-based charges, we expect to continue to incur substantial operating losses for the foreseeable future. Our clients tend to spend proportionally more on our services during the second and third quarters and we expect this seasonality trend may continue in the near future. This has caused our past operating results to fluctuate significantly from quarter to quarter. Our expansion places significant demands on our management and operational resources. We may be unable to manage our growth effectively and as a result, our expenses could increase more quickly than our revenues. To the extent that future revenues do not increase significantly in the same periods in which operating expenses increase, our operating results would be adversely affected. In addition, although we have experienced significant percentage growth in annual revenues to date, we do not believe that prior growth rates are sustainable or indicative of future operating results. Please refer to the section entitled "Factors That May Affect Results" for additional information. RESULTS OF OPERATIONS The following table presents our consolidated statement of operations as a percentage of revenues for the periods indicated. We derived this data from our unaudited condensed consolidated financial statements contained in this Quarterly Report on Form 10-Q which, in our opinion, include all normal recurring adjustments necessary to fairly present the results of operations for the periods shown. This information should be read in conjunction with our audited consolidated financial statements and notes thereto included in our 9 12 Annual Report on Form 10-K for the year ended December 31, 1999. The operating results for any period are not necessarily indicative of the results that may be expected for any future period.

THREE MONTHS ENDED SIX MONTHS ENDED JUNE 30, JUNE 30, ------------------- ------------------ 2000 1999 2000 1999 ------ ------- ------ ------ Revenues............................................ 100.0% 100.0% 100.0% 100.0% Operating expenses: Professional services............................. 48.9% 47.9% 51.9% 50.6% Selling, general and administrative............... 59.7% 48.2% 63.5% 47.4% Stock compensation and other stock-based charges........................................ 28.5% 12.6% 52.7% 10.6% ----- ------ ------ ------ Total operating expenses.................. 137.1% 108.7% 168.1% 108.6% Operating loss...................................... (37.1)% (8.7)% (68.1)% (8.6)% Minority interest in operations of consolidated subsidiary........................................ 0.0% 0.0% 0.1% 0.1% Investment loss..................................... (0.9)% 0.0% (0.5)% 0.0% Interest income, net................................ 3.5% 0.2% 2.4% 0.0% ----- ------ ------ ------ Net loss before taxes.......................... (34.5)% (8.5)% (66.1)% (8.5)% Income tax expense.................................. 0.6% 0.1% 0.6% 0.1% ----- ------ ------ ------ Net loss....................................... (35.1)% (8.6)% (66.7)% (8.6)% ===== ====== ====== ======

COMPARISON OF THREE AND SIX MONTHS ENDED JUNE 30, 2000 AND 1999 REVENUES Our revenues were $37.2 million for the three months ended June 30, 2000, an increase of 115.2% over $17.3 million for the three months ended June 30, 1999. Our revenues were $66.4 million for the six months ended June 30, 2000, an increase of 142.7% over $27.4 million for the six months ended June 30, 1999. These increases were primarily due to increases in the number of clients and the size and scope of our engagements, attributable in part to our differentiated service offering, customer service and fulfillment consulting and transaction management services, and our rate card increase effected in the first quarter of 2000. Our increased sales and marketing efforts resulted in the addition of many new accounts and the expansion of our relationship with many existing clients since June 30, 1999, most notably DaimlerChrysler, which accounted for 18.7% and 18.2% of our total revenues for the three and six months ended June 30, 2000, respectively. Since June 30, 1999, we continued our global expansion by opening offices in Singapore, Toronto and Atlanta. Revenues from our international locations were significantly higher than the amounts generated during the comparable periods in the prior year, representing 10.4% and 9.7% of our total revenues for the three and six months ended June 30, 2000, respectively. PROFESSIONAL SERVICES Our professional services expenses were $18.2 million for the three months ended June 30, 2000, an increase of 119.7% over $8.3 million for the three months ended June 30, 1999. Our professional services expenses were $34.5 million for the six months ended June 30, 2000, an increase of 149.4% over $13.8 million for the six months ended June 30, 1999. These increases were primarily due to increases in our salary costs associated with the increase in professional services personnel. The global increase in professional services headcount resulted from opening new offices since June 30, 1999 in Singapore, Toronto and Atlanta as well as continued growth in our other worldwide offices in order to accommodate the increase in the size and number of our projects. As a percentage of revenues, professional services expenses remained relatively constant at 48.9% and 47.9% for the three months ended June 30, 2000 and 1999, respectively, and at 51.9% and 50.6% for the six months ended June 30, 2000 and 1999, respectively. 10 13 SELLING, GENERAL AND ADMINISTRATIVE Our selling, general and administrative expenses were $22.2 million for the three months ended June 30, 2000, an increase of 167.1% over $8.3 million for the three months ended June 30, 1999. Our selling, general and administrative expenses were $42.1 million for the six months ended June 30, 2000, an increase of 224.8% over $13.0 million for the six months ended June 30, 1999. These increases resulted from the hiring of key corporate officers, increased facilities, rent and depreciation costs associated with our new offices as previously mentioned, and increased recruiting costs associated with the increase in personnel. As a percentage of revenues, selling, general and administrative expenses increased to 59.7% from 48.2% for the three months ended June 30, 2000 and 1999, respectively, and to 63.5% from 47.4% for the six months ended June 30, 2000 and 1999, respectively. These increases were the result of our aggressive investment in infrastructure support costs relative to our revenue growth, partly attributable to costs associated with hiring executive management and personnel to fill open positions within the corporate services departments. We believe that our current commitment to building our global platform and scalable infrastructure will, in turn, result in greater efficiencies in the future. STOCK COMPENSATION AND OTHER STOCK-BASED CHARGES Stock compensation and other stock-based charges consist of non-cash compensation expenses arising from stock option grants and the issuance of a warrant to Omnicom Group. For the three months ended June 30, 2000 and 1999, we recorded aggregate deferred stock-based compensation of $0 and $14.3 million, respectively. This decrease was due to no options being granted during the three months ended June 30, 2000 at exercise prices that were less than the market values at the time of grant. For the six months ended June 30, 2000 and 1999, we recorded aggregate deferred stock-based compensation of $34.8 million and $18.0 million, respectively. This increase was primarily due to an increase in the number of option grants since June 30, 1999 and the larger differences between the market values at the dates of grant and the exercise prices at which the options were granted from June 30, 1999 through January 18, 2000. These amounts have been included as a component of stockholders' equity and are being amortized by charges to operations over the vesting period of the related options, generally 4 years. We recognized stock compensation expense of $9.1 million and $2.2 million for the three months ended June 30, 2000 and 1999, respectively, and $32.0 million and $2.9 million for the six months ended June 30, 2000 and 1999, respectively. As of June 30, 2000, we had $66.6 million of deferred stock-based compensation remaining to be amortized. The amortization of deferred stock-based compensation will result in additional charges to operations through fiscal 2003. In connection with the $30.0 million revolving credit facility obtained on August 27, 1999, we issued a warrant on September 13, 1999 that entitled Omnicom Group to purchase 2,249,076 shares of common stock and recorded a deferred bank facility charge of approximately $18.2 million. This amount is being amortized on a straight-line basis over the longer of 36 months, the term of the credit facility, or until the credit facility is terminated. For the three and six months ended June 30, 2000, we recognized bank facility expense of $1.5 million and $3.0 million, respectively. INVESTMENT LOSS For the three months ended June 30, 2000, we recognized non-recurring investment losses totaling $353,000. The investment losses related primarily to a write-off for NextPlanetOver, which was purchased by eHobbies with no residual value to the existing shareholders. INTEREST INCOME, NET Interest income, net represents the excess of interest income generated from our cash and cash equivalents and short-term investments over interest expense incurred on our financing obligations. We recognized interest income, net of $1.3 million and $36,000 for the three months ended June 30, 2000 and 1999, respectively, and $1.6 million and $15,000 for the six months ended June 30, 2000 and 1999, respectively. The increases were due to additional income generated from our initial public offering proceeds. We invested our cash balances in treasury reserves as of June 30, 2000. We expect interest income to continue 11 14 to increase, as we intend to invest the proceeds from our initial public offering in higher interest-bearing securities. LIQUIDITY AND CAPITAL RESOURCES On February 10, 2000, we completed an initial public offering of 6,325,000 shares of our common stock (including the exercise of the underwriters' over-allotment option) at $20.00 per share and realized net proceeds of approximately $115.8 million. The primary purposes of this offering were to obtain additional equity capital to assist with our present growth strategies, create a public market for our common stock, and facilitate future access to public markets. We have used, and expect to continue to use, the proceeds for general corporate purposes, including working capital and capital expenditures. A portion of the proceeds may also be used for the acquisition of businesses that are complimentary to ours. Pending such uses, we have invested the net proceeds of this offering in treasury reserves. Prior to our initial public offering, we primarily financed our operations through the issuance of convertible preferred stock, borrowings under equipment lines of credit, and borrowings under a revolving credit facility. As of June 30, 2000, we had $89.4 million in cash and cash equivalents and our principal commitments consisted of obligations outstanding under capital leases and software financing agreements. Net cash used in operating activities was $10.6 million and $4.0 million for the six months ended June 30, 2000 and 1999, respectively. Net cash flows used in operating activities in each period reflect net losses and increases in accounts receivable and costs in excess of billings, partially offset by an increase in the amortization of deferred stock-based compensation. Net cash used in investing activities was $15.3 million and $3.6 million for the six months ended June 30, 2000 and 1999, respectively. Net cash flows used in investing activities for the six months ended June 30, 2000 primarily reflect increased purchases of property and equipment. Net cash flows used in investing activities for the six months ended June 30, 1999 reflect increased purchases of property and equipment and short-term investments, partly offset by the proceeds from sales of short-term investments. Net cash provided by financing activities was $107.1 million and $10.3 million for the six months ended June 30, 2000 and 1999, respectively. Net cash provided by financing activities for the six months ended June 30, 2000 was primarily due to our initial public offering and, to a lesser extent, the exercises of common stock options, partially offset by the repayment of our borrowings under the revolving credit facility as described below. Net cash provided by financing activities for the six months ended June 30, 1999 was primarily due to the issuance of Series B convertible preferred stock as described below. Capital expenditures, excluding capital leases, were $14.8 million and $2.7 million for the six months ended June 30, 2000 and 1999, respectively. Our capital expenditures consisted of purchases of operating resources, including computer equipment, computer software, other internal software implementations and leasehold improvements. Since inception, we have generally funded capital expenditures through the use of capital leases, equipment lines of credit and software financing agreements. We expect that our capital expenditures will continue to increase in the future, in part due to the relocation of our headquarters in San Francisco, and that these expenditures will be primarily for the purchase of computer equipment, computer software, internal software implementations and leasehold improvements. In February 1999, we issued 1,488,000 shares of Series B convertible preferred stock to Omnicom Group for net cash proceeds of $7.7 million plus the settlement of a $3.0 million short-term bridge loan that was extended to us in January 1999. On August 27, 1999, we entered into a revolving credit facility with Omnicom Group that allowed us to borrow up to $30.0 million at the lender's commercial paper rate plus 3.0% until the closing of our initial public offering. The revolving credit facility is primarily used for working capital purposes. This credit facility contains certain restrictions and any borrowings under the credit facility require us to comply with financial covenants and are secured by some of our investments. These financial covenants include minimum revenue targets and limitations on capital equipment purchases. Upon the closing of our initial public offering on February 18, 2000, the borrowing limit available under the revolving credit facility was reduced to 12 15 $15.0 million at the lender's commercial paper rate plus 1.25% through September 30, 2002 and the amount outstanding including interest was repaid in full. As of June 30, 2000 there were no borrowings outstanding under this credit facility. We believe that our current level of cash and cash equivalents will be sufficient to meet our anticipated liquidity needs for working capital and capital expenditures for at least twelve months from June 30, 2000. RECENT ACCOUNTING PRONOUNCEMENTS We continually assess the effects of recently issued accounting standards. The impact of all recently adopted and issued accounting standards has been disclosed in the notes to the unaudited condensed consolidated interim financial statements in this Quarterly Report on Form 10-Q. FACTORS THAT MAY AFFECT RESULTS In addition to other information in this Quarterly Report on Form 10-Q, the following risk factors should be read carefully when evaluating us and our business because such factors currently may have a significant impact on our business, operating results, financial condition and cash flows. Our actual results could differ materially from those projected in any forward-looking statements as a result of the risk factors set forth below and elsewhere in this Quarterly Report on Form 10-Q and the risks discussed in our Registration Statement on Form S-1 declared effective on February 9, 2000 by the Securities and Exchange Commission (File No. 333-91627) and Annual Report on Form 10-K filed on May 8, 2000. RISKS RELATED TO ORGANIC WE MAY BE UNABLE TO RECRUIT AND RETAIN THE TALENTED PERSONNEL WHO ARE ESSENTIAL FOR COMPLETING CLIENT PROJECTS, WHICH COULD HARM OUR PERFORMANCE ON EXISTING PROJECTS AND REDUCE OUR ABILITY TO OBTAIN NEW PROJECTS. Our business is labor intensive, and thus our success depends on identifying, hiring, training and retaining talented professionals. All of our current employees and senior managers are employed on an at-will basis. If a significant number of our current employees, contractors or any of our senior managers leave, we may be unable to complete or retain existing projects or bid for new projects of similar scope and revenues. Even if we retain our current employees and contractors, our management must continually recruit talented professionals for our business to grow. However, competition for these employees is intense, particularly in the Internet and high technology industries. In addition, our industry and business are subject to high turnover rates among employees. As a result, we may be unable to successfully attract, assimilate or retain qualified personnel. As of June 30, 2000, we had 1,220 employees, and we expect to hire additional personnel to support our business. The failure to retain or attract the necessary personnel would reduce our capacity to handle new client engagements and therefore our revenue growth, which would seriously harm our business, financial condition, results of operations and cash flows. WE MAY BE UNABLE TO EFFECTIVELY MANAGE OUR RAPID GROWTH, WHICH COULD RESULT IN OUR BEING UNABLE TO EFFECTIVELY CONTROL OUR COSTS AND IMPLEMENT OUR BUSINESS STRATEGIES. We plan to continue our global expansion to address the anticipated growth in our client base and market opportunities. We also believe expansion into new geographic areas is important in order to serve clients more efficiently and effectively. Because competition for employees in many of these new geographic areas is intense, our employee recruitment for these areas may at times exceed or fall below our requirements for engagements in these geographic areas. Our current expansion has placed, and any future expansion may continue to place, a significant strain on our managerial, operational, financial and other resources. If we are unable to manage growth effectively or if we experience difficulties in effecting our expansion, our expenses could increase more quickly than our revenues or our revenues could decline as a result of our failure to service new client engagements adequately, either of which would seriously harm our business, financial condition, results of operations and cash flows. 13 16 OUR REVENUES COULD BE SIGNIFICANTLY REDUCED BY THE LOSS OF A MAJOR CLIENT. We derive a significant portion of our revenues from a limited number of clients. The loss of any major client, if not replaced, could dramatically reduce our revenues. For example, for the six months ended June 30, 2000, our five largest clients accounted for 48.3% of our total revenues, with DaimlerChrysler accounting for 18.2% of our revenues. WE MAY HAVE MORE DIFFICULTY COLLECTING OUR ACCOUNTS RECEIVABLE FROM EMERGING GROWTH AND START-UP CLIENTS THAN OTHER CLIENTS, WHICH MAY AFFECT OUR REVENUES AND DAMAGE OUR POTENTIAL PROFITABILITY. Currently, approximately 25% of our revenues are derived from services provided to emerging growth and start-up companies. We believe that we may face certain risks in doing business with emerging growth and start-up clients that we may not face with our mature or established "brick and mortar" clients, including the ability of these clients to raise additional funds on favorable terms or at all. Unless we are diligent in invoicing and collecting amounts during the beginning stages of our engagements, we believe we may experience longer payment cycles and problems in collecting accounts receivable with respect to emerging growth and start-up clients. Additionally, our clients or potential clients' inability to raise additional funds may cause them to terminate or reduce the scope of the services we provide them, which could affect our business, financial condition, operating results and cash flows. OUR LACK OF LONG-TERM CONTRACTS WITH OUR CLIENTS REDUCES THE PREDICTABILITY OF OUR REVENUES. We generally do not have long-term contracts with our clients but instead are retained on an engagement-by-engagement basis. These engagements vary in size and scope and thus make our revenues difficult to predict. In addition, generally our contract provides for termination by either party after notice and a transition period of up to 180 days. Our clients also could unilaterally reduce or modify the scope or use of our services. Our operating expenses are relatively fixed and cannot be reduced on short notice to compensate for such unanticipated variations in the number or size of engagements in progress. Because we incur costs based on our expectations of revenues from future engagements, our failure to predict our revenues accurately may cause the increase in our expenses to outpace our revenue growth substantially, which would seriously harm our financial condition, results of operations and cash flows. IF WE FAIL TO ACCURATELY PREDICT COSTS RELATED TO OUR FIXED-FEE PROJECTS, WE MAY LOSE MONEY. Most of our current projects are on a fixed-fee basis, rather than on a time and materials basis. Often, we fix the fee and timeframe before we finalize the design specifications. The risk of miscalculations in pricing is high because we work with complex technologies in compressed timeframes, and therefore it can be difficult to judge the time and resources necessary to complete a project. If we miscalculate the resources or time necessary to complete our projects, we could have cost overruns and we could lose money on these projects, which could seriously harm our operating results. WE MAY HAVE DIFFICULTY IN MANAGING OUR INTERNATIONAL EXPANSION AND OPERATIONS, WHICH COULD HARM OUR BUSINESS AND FINANCIAL CONDITION. A key element of our strategy is to expand our business into international markets. In addition to our domestic operations, we have operations in Sao Paulo, Brazil, which opened in February 1999; London, England, which opened in April 1999; Singapore, which opened in September 1999; and Toronto, Canada, which opened in January 2000. Our international offices provide the same or similar services as our domestic offices, sometimes in conjunction with our domestic offices. Our management may have difficulty in managing our international operations because of distance, as well as language and cultural differences. Our management cannot assure you that they will be able to market and deliver our services successfully in foreign markets. 14 17 Other risks related to our international operations include: - failure in finding or acquiring suitable strategic acquisition candidates; - difficulties arising from staffing and managing foreign operations; - compliance with legal and regulatory requirements of various countries, including differing tax or labor laws; - difficulties in using equity incentives for employees; - international currency issues, including fluctuations in currency exchange rates; - restrictions on the import and export of sensitive technologies, including data security and encryption technologies that we may wish to use in solutions we develop for clients; and - political or economic instability. If any of these risks should materialize, our international and domestic businesses, financial conditions, results of operations and cash flows could be harmed. Our revenues derived from international operations were 10.4% and 9.7% of our total revenues for the three and six months ended June 30, 2000, respectively. OUR BILLABLE EMPLOYEES MAY BE UNDERUTILIZED IF CLIENTS DO NOT RETAIN OUR SERVICES, WHICH MAY DAMAGE OUR PROFITABILITY. Some of our clients who utilize our services in multiple stages or engagements may choose not to retain our services for additional stages of a project or may choose to cancel or delay additionally planned projects. Such cancellations or delays could result from factors entirely unrelated to our work, but instead related to general business or financial condition of the client. If a client defers, modifies or cancels an engagement or chooses not to retain our services for additional phases of a project, we may be unable to rapidly re-deploy our employees to other engagements, to minimize under-utilization of those employees. This under-utilization could reduce our revenues and gross margins and damage our potential profitability. For example, if DaimlerChrysler, the primary client of our Detroit, Michigan office in 1999, chose not to retain our services, the billable employees in our Detroit office could be underutilized. HISTORICALLY, WE HAVE GRANTED OPTIONS TO PURCHASE COMMON STOCK AT LOW EXERCISE PRICES, WHICH WILL RESULT IN ADDITIONAL COMPENSATION EXPENSE IN THE FUTURE AND REDUCE OUR REPORTED EARNINGS. Historically we have granted employees options to purchase our common stock at exercise prices below the deemed fair market value on the date of grant. For the six months ended June 30, 2000, we granted options to purchase 4,995,000 shares of common stock to employees with exercise prices ranging from $3.00 to $30.13 per share. We recognized stock-based compensation expense of $9.1 million and $32.0 million for the three and six months ended June 30, 2000, respectively, relating to the difference between the exercise price of the options and the fair market value of our common stock on the dates of grant. As of June 30, 2000, we had $66.6 million of deferred stock-based compensation remaining that will be recognized as the options vest over the next four years which will dilute any future earnings that we may achieve. WE ARE LIKELY TO EXPERIENCE SIGNIFICANT FLUCTUATIONS IN OUR QUARTERLY OPERATING RESULTS THAT MAY MAKE THE PRICE OF OUR COMMON STOCK DIFFICULT TO PREDICT. Our quarterly operating results have varied in the past and we expect that our revenues and operating results will continue to fluctuate significantly from quarter to quarter due to a variety of factors, many of which are outside of our control. Some important factors affecting our revenues and operating results from quarter to quarter, in order of their relative magnitude are: - changes in our operating expenses as we expand globally; - timing and execution of major client engagements; 15 18 - the timing and cost of advertising and related media; - timing of employee hiring and utilization rates; - increases in the number of independent contractors we must hire to meet client needs, which would result in increased costs versus an equivalent number of employees; - our ability to develop, market and introduce new and significant online business solutions on a timely basis; - our success in obtaining suitable locations for expansion; - our clients' purchasing cycles; - pricing changes in the industry; - demand for our Internet professional services; - economic conditions in the Internet professional services market; and - legal or regulatory developments regarding the Internet. Furthermore, we are subject to employer payroll taxes when our employees exercise their non-qualified stock options. The employer payroll taxes are assessed on each employee's gain, which is the difference between the market price of our common stock on the date of exercise and the exercise price. These employer payroll taxes will be recorded as operating expenses in the period those options are exercised based on the aggregate gains realized by employees. During a particular quarter, these payroll taxes could be material. However, because we are unable to predict our future stock price and the number of optionees who may exercise during any particular quarter, we cannot predict what, if any, expense will be recorded in a future quarter and the impact on our future operating results. Our quarterly revenues and operating results are volatile and difficult to predict. It is likely that in some future quarter or quarters our operating results will be below the expectations of public market analysts or investors. In such event, the market price of our common stock may decline significantly. THE HISTORICAL SEASONALITY OF OUR REVENUES COULD CAUSE OUR QUARTERLY OPERATING RESULTS TO FALL BELOW THE EXPECTATIONS OF MARKET ANALYSTS AND INVESTORS, WHICH COULD HAVE A NEGATIVE EFFECT ON THE MARKET PRICE OF OUR COMMON STOCK. Historically, our clients have concentrated their expenditures on our services in the second and third quarters of the calendar year. This concentration of expenditures has resulted in quarterly fluctuations in revenues, and could cause our revenues to decline on a sequential basis in the future. If these fluctuations or declines are greater than market analysts or investors expect, our stock price could decline. WE HAVE A HISTORY OF LOSSES AND WE MAY EXPERIENCE LOSSES IN THE FUTURE, WHICH COULD RESULT IN A DECLINE IN THE MARKET PRICE OF OUR COMMON STOCK. We have experienced operating losses as well as net losses for the three and six months ended June 30, 2000 and 1999. Our net losses were $13.1 million and $1.5 million for the three months ended June 30, 2000 and 1999, respectively, and $44.3 million and $2.3 million for the six months ended June 30, 2000 and 1999, respectively. Our net losses were 35.1% and 8.6% of total revenues for the three months ended June 30, 2000 and 1999, respectively, and 66.7% and 8.6% of total revenues for the six months ended June 30, 2000 and 1999, respectively. We may not be able to sustain the revenue growth we have experienced or the levels of revenues obtained previously. In addition, we intend to continue to invest heavily in development of our infrastructure and recruiting. As a result, we will need to generate significant revenues to achieve profitability. We cannot assure you that we will achieve profitability in the future or, if we achieve profitability, that we will be able to sustain it. If we do not achieve and maintain profitability, the market price for our common stock may decline substantially. 16 19 WE RELY ON THE SERVICES OF OUR SENIOR MANAGEMENT AND OTHER KEY PERSONNEL, WHOSE KNOWLEDGE OF OUR BUSINESS AND TECHNICAL EXPERIENCE WOULD BE DIFFICULT TO REPLACE. We believe that our success will depend on the continued employment of our senior management team and other key personnel. Any of our officers or employees can terminate his or her employment relationship at any time. Currently, our key executives are Jonathan Nelson, our Chief Executive Officer and Chairman of the Board, and Michael Hudes, our President. The loss of either of these key employees or our inability to attract or retain other qualified employees could harm our business, financial condition and results of operations. While we currently maintain a key person life insurance policy for Jonathan Nelson, the amount of this insurance may be inadequate to compensate us for his loss. WE WILL LIKELY CONTINUE TO FACE INTENSE COMPETITION WHICH COULD HARM OUR OPERATING RESULTS. The market for Internet professional services is relatively new, intensely competitive, quickly evolving and subject to rapid technological change. In addition, our industry is experiencing rapid consolidation. Moreover, many of our competitors have longer operating histories, larger client bases, greater brand recognition, greater financial, marketing, service, support, technical, intellectual property and other resources than we do. As a result, our competitors may be able to devote greater resources to marketing campaigns, adopt more aggressive pricing policies or devote substantially more resources to client and business development than us. We also anticipate facing additional competition from new entrants into our markets due to the low barriers of entry. This increased competition may result in reduced operating margins, loss of market share and a diminished brand. In addition, we may from time to time make pricing, service or marketing decisions or acquisitions as a strategic response to changes in the competitive environment. These actions could reduce our profits and harm our financial condition, results of operations and cash flows. OUR INVESTMENTS IN CLIENT COMPANIES INVOLVE RISK, INCLUDING LOSING SOME OR ALL OF OUR INVESTMENT, WHICH COULD HARM OUR OPERATING RESULTS. In exchange for our services we have from time to time made investments in some of our clients. As of June 30, 2000, we had $6.2 million of such investments accounted for on our balance sheet. We may continue to invest in our clients as opportunities arise. In general, these equity investments are structured so our clients pay for all of the costs related to their engagement in cash and use equity incentives to compensate us for a portion of our profit margin. The businesses of the clients in which we invest, however, are generally unproven and involve substantial risk. If these clients' businesses do not succeed, we could lose some or all of our investment, which would harm our operating results and cause our profitability to be lower than it would have been if we had taken payment for our entire engagement in cash. OUR BUSINESS OPPORTUNITIES MAY BE RESTRAINED BY CONFLICTS BETWEEN POTENTIAL CLIENTS, WHICH COULD REDUCE OUR POTENTIAL PROFITABILITY. Conflicts between potential clients are inherent in our business. We have in the past, and will likely in the future, be unable to pursue certain opportunities because they would result in offering similar services to direct competitors of existing clients. Moreover, we risk alienating existing clients if we provide services to even indirect competitors. Because these potential conflicts may jeopardize revenues generated from existing clients and hinder future prospects, these conflicts could cause our operating results to suffer. Furthermore, in limited circumstances, we have agreed not to reuse some software code developed by us for a client for competitors of the client and, in the case of DaimlerChrysler, not to perform work for particular competitors. These types of agreements reduce the number of our prospective clients and the number of potential sources of revenues. Accordingly, our use of these types of agreements magnifies the importance of our client selection process because many of our clients compete in markets where only a limited number of players gain meaningful market share. If we agree not to perform services for a particular client's competitors and our client fails to capture a significant portion of its market, our future revenues in that particular market will be negatively impacted. 17 20 WE FACE POTENTIAL LIABILITY FOR DEFECTS OR ERRORS IN THE SOLUTIONS WE DEVELOP, THE OCCURRENCE OF WHICH COULD REDUCE OUR REVENUES. Many of the solutions we develop are critical to the operations of our clients' businesses. Any defects or errors in these solutions could result in: - delayed or lost client revenues; - adverse client reaction to us; - negative publicity; - additional expenditures to correct the problem; or - claims against us for negligence in performing our services or for errors in the software code provided by us. Our standard contracts limit our damages arising from our negligent conduct and for other potential liabilities in rendering our services. However, these contractual provisions may not protect us from liability for damages. In addition, large claims may not be adequately covered by insurance or may raise our insurance costs. IF WE ARE UNABLE TO ADEQUATELY PROTECT OUR INTELLECTUAL PROPERTY RIGHTS, OUR REPUTATION COULD BE DAMAGED AND OUR COMPETITIVE POSITION COULD BE HARMED. We believe our trademarks, trade secrets and other proprietary rights in our intellectual property, including our trademark name, Organic, software code and Internet business processes we have developed, are important to our success and competitive position. In particular, our trademarks help establish our brand identity and enhance the marketability of our services. Our trade secrets, including the Internet business processes we have developed, are a significant aspect of the services we provide. If we are unable to protect our trademarks, trade secrets and other intellectual property against unauthorized use by others, our reputation among existing and potential clients could be damaged and our competitive position could be harmed. We generally enter into confidentiality or license agreements with our employees and consultants, and generally control access to and distribution of our documentation and other proprietary intellectual property. Despite these precautions, our management cannot ensure that these strategies will be adequate to deter misappropriation of our proprietary intellectual property. Despite efforts to protect our intellectual property, we also face the following risks: - non-recognition or inadequate protection of our proprietary rights; - undetected misappropriation of our proprietary intellectual property or materials; - development of similar technologies by competitors; - unenforceability of non-competition agreements entered into by our employees; and - infringement claims, even if not meritorious, against us. If any of these risks materialize, we could be required to pay significant amounts to defend our rights and in some cases to indemnify our customers. WE MAY BE UNABLE TO MEET OUR FUTURE CAPITAL REQUIREMENTS AND MAY REQUIRE ADDITIONAL FINANCINGS. Our future liquidity and capital requirements will depend on numerous factors, including: - timing and amount of funds required for, or generated by, operations; - success and duration of our global expansion program; and - unanticipated opportunities or challenges. 18 21 If our cash flows from operations and existing liquidity resources are insufficient to fund our operations, we may need to obtain additional equity or debt financing. In this case, we may seek to raise additional funds through public or private financings, strategic relationships or other arrangements. This additional funding may not be available on terms acceptable to us, or at all. We may have to sell stock at prices lower than those paid by existing stockholders, which would result in dilution, or we may have to sell stock or bonds with rights superior to rights of holders of common stock. Also, any debt financing might involve restrictive covenants that would limit our operating flexibility. Moreover, strategic arrangements may require us to relinquish our rights to certain of our intellectual property. Finally, if adequate funds are not available on acceptable terms, we may be unable to develop or enhance our services, take advantage of future opportunities or respond to the competitive market. THE SUBSTANTIAL NUMBER OF SHARES THAT WILL BE ELIGIBLE FOR SALE IN THE NEAR FUTURE MAY ADVERSELY AFFECT THE MARKET PRICE OF OUR COMMON STOCK. In connection with the initial public offering of our common stock, stockholders holding shares of our common stock prior to our initial public offering agreed to lock-up restrictions with the underwriters that prohibited the sale of their shares until 180 days after the effective date of our Registration Statement on Form S-1, subject to restrictions set forth in Rules 144 and 701 under the Securities Act of 1933. At July 31, 2000, the total number of our shares subject to the lock-up restrictions was 81,631,512, of which 51,954,975 and 14,983,101 shares are beneficially owned by Organic Holdings, Inc. and Omnicom Group, respectively. The 180-day period and the lock-up restrictions will end on August 8, 2000. Sales of a substantial number of shares of common stock in the public market following the expiration of the lock-up restrictions could cause the market price for our common stock to decline. RISKS RELATED TO OUR INDUSTRY OUR SUCCESS DEPENDS ON OUR CLIENTS' WILLINGNESS TO ADOPT AN INTERNET BUSINESS MODEL AND OUTSOURCE THEIR INTERNET NEEDS TO INTERNET PROFESSIONAL SERVICE PROVIDERS. The market for our services depends upon the adoption and assimilation of Internet professional services by companies. Critical issues concerning the use of the Internet remain unresolved and may affect the use of these technologies to solve business problems. Critical issues that influence a client to adopt an Internet business model or expand its business on the Internet include: - security of Internet technologies and client information; - reliability of the technology and services; - cost of development of an electronic business Web site; and - administration and bandwidth of the Internet itself. The process of implementing or expanding a business on the Internet can be difficult. The difficulty expected or experienced by clients in utilizing the Internet and the expected costs of outsourcing compared to the expected costs of internal development will affect their decisions on hiring and retaining Internet professional services providers. Many entities may choose not to outsource their Internet needs. Additionally, some entities would have to make significant changes in their current business practice to adapt to the Internet. Thus, even if the above listed issues were resolved, businesses may just choose not to adopt an Internet business model. 19 22 IF WE ARE UNABLE TO KEEP UP WITH RAPID TECHNOLOGICAL AND OTHER CHANGES IN THE INTERNET AND THE ELECTRONIC COMMERCE INDUSTRY, OUR BUSINESS WILL BE HARMED. To remain competitive, we must continue to enhance and improve the responsiveness, functionality and features of our online business solutions. The Internet and the electronic commerce industry are characterized by rapid technological change, changes in user and client requirements and preferences, frequent new product and service introductions embodying new technologies, and the emergence of new industry standards and practices. The evolving nature of the Internet could render obsolete both our proprietary technology and the skills of our employees. Our success will depend, in part, on our ability to: - effectively use leading technologies critical to our business; - enhance our existing solutions; - continue to develop new solutions and technology that address the increasingly sophisticated and varied needs of our current and prospective clients and their customers; and - influence and respond to technological advances, emerging industry and regulatory standards and practices and competitive service offerings. Our ability to remain technologically competitive may require substantial expenditures and lead-time. If we are unable to adapt in a timely manner to changing market conditions or customer requirements, our business, financial condition, results of operations and cash flows could be seriously harmed. OUR REVENUES COULD BE HARMED IF GROWTH IN THE USE OF THE INTERNET OR GROWTH OF ELECTRONIC COMMERCE DOES NOT CONTINUE. Our future success is substantially dependent upon continued growth in the use of the Internet, particularly growth in commerce over the Internet. However, consumer use of the Internet for commerce may not grow as quickly as projected. If the number of users on the Internet does not increase or commerce over the Internet does not become more accepted and widespread, demand for our services may decrease and, as a result, our revenues would decline. Capacity constraints caused by growth in Internet usage may, unless resolved, impede further growth in Internet use. Other factors that may affect Internet usage or electronic commerce adoption include: - actual or perceived lack of security of information; - lack of access and ease of use; - congestion of Internet traffic; - inconsistent quality or availability of Internet or customer service; - possible outages due to difficulties or other damage to the Internet; - excessive governmental regulation; - uncertainty regarding intellectual property ownership; - costs associated with the obsolescence of existing infrastructure; and - level of consumer satisfaction with electronic commerce experiences. Further, the adoption of the Internet for commerce and communication, particularly by those individuals and companies that have historically relied upon alternative means of commerce and communication, generally require the understanding and acceptance of a new way of conducting business and exchanging information. In particular, companies that have already invested substantial resources in traditional means of conducting commerce and exchanging information may be particularly reluctant or slow to adopt a new Internet-based strategy. If the necessary infrastructure, products, services or facilities are not developed, or if the Internet does not become a viable commercial medium, our business, financial condition, results of operations and cash flows could be harmed. 20 23 THE APPLICATION OR ADOPTION OF GOVERNMENT REGULATIONS AND THE EXISTENCE OF LEGAL UNCERTAINTIES MAY HARM OUR BUSINESS. We and our clients are subject both to regulations applicable to businesses generally and to regulations directly applicable to electronic commerce. However, laws and regulations may at any time be modified or adopted with respect to the Internet relating to user privacy, pricing, content, copyrights, distribution and characteristics and quality of products and services. The modification or adoption of any additional laws or regulations may stall the expansion of the Internet, which could increase our cost of doing business or decrease demand for our online business solutions. In addition, the applicability of existing laws to the Internet remains uncertain with regard to many issues including property ownership, export of encryption technology, sales tax, libel and personal privacy. Any new legislation or regulation in these areas could potentially harm our business, financial condition and results of operations. Finally, the application of laws and regulations of jurisdictions where we plan to offer our Internet services could also limit our business. Other states or foreign countries may: - require us to qualify to do business as a foreign corporation in each state or foreign country, or otherwise subject us to taxes and penalties; - attempt to regulate our Internet solutions; - prosecute us for unintentional violations of their laws; or - modify or enact new laws in the near future. YEAR 2000 The information provided below constitutes a "Year 2000 Readiness Disclosure" for purposes of the Year 2000 Information and Readiness Disclosure Act. The year 2000 problem existed because many computer systems and software products use only the last two digits to refer to a year, creating the potential for computerized programs to treat "00" as the year 1900, rather than as the year 2000, in date-sensitive calculations. In our Registration Statement on Form S-1 declared effective on February 9, 2000 by the Securities and Exchange Commission (File No. 333-91627), we discussed the nature and progress of our plans to prepare for any system or processing failures that could occur as a result of this problem. In late 1999, we completed our review of our year 2000 readiness programs, including our assessment of our internal systems as well as those of third parties with whom we have material interactions. As a result of our planning and implementation efforts, we have experienced to date no significant disruptions in either our internal operations or in our client deliverables. The few issues that have been noted were dealt with at the time they arose. Our costs to date concerning the year 2000 problem have not been material. We are not aware of any material problems resulting from year 2000 issues, either with our internal systems, our software products, or the products and services we deliver to our clients. We will continue to monitor both our internal operations and those of our vendors and clients throughout the year 2000 to ensure that any latent year 2000 matters that may arise are addressed promptly. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Information concerning our exposure to market risk, which has remained relatively unchanged from December 31, 1999, is incorporated by reference to the discussion under the caption "Quantitative and Qualitative Disclosures About Market Risk" in Part II, Item 7A of our Annual Report on Form 10-K for the year ended December 31, 1999. 21 24 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS On May 16, 2000, an individual real estate broker and former employee of a real estate brokerage company which had performed some work for us filed suit in United States District Court in New York City seeking recovery from us and others for broker's commissions he claims due. (Kades v. Organic, Inc., et al.) The complaint alleges claims for violation of the Racketeering Influenced Corrupt Organizations (RICO) Act, misrepresentation, interference with contractual relations and other causes of action and seeks compensatory and punitive damages against all defendants. The lawsuit is in its initial stages. We believe the complaint is without merit and intend to contest the claims vigorously. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) EXHIBITS INDEX: The following is a list of exhibits filed as part of this Quarterly Report on Form 10-Q. Where so indicated by footnote, exhibits that were previously filed are incorporated by reference. For exhibits incorporated by reference, the location of the exhibit in the previous filing is the same as those set forth below.

EXHIBIT NUMBER DESCRIPTION ------- ------------------------------------------------------------ 3.1 Amended and Restated Certificate of Incorporation of Registrant(1) 3.2 Amended and Restated Bylaws of Registrant(1) 4.1 Reference is made to Exhibits 3.1 and 3.2 4.2 Specimen Certificate of the Registrant's common stock(1) 4.3 Rights Agreement between Registrant and EquiServe Trust Company, N.A., as Rights Agent(2) 4.4 Investors' Rights Agreement by and among Registrant, Organic Holdings, Inc. and Omnicom Group, Inc., dated February 8, 2000(1) 27.1 Financial Data Schedule(3)

--------------- (1) Incorporated herein by reference to the Company's Registration Statement on Form S-1 (File No. 333-91627). (2) Incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1999. (3) Filed herewith. (b) REPORTS ON FORM 8-K None. 22 25 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, Organic, Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ORGANIC, INC. (Registrant) By: /s/ SUSAN L. FIELD ------------------------------------ Susan L. Field Executive Vice President and Chief Financial Officer By: /s/ SHELLY A. SAUNDERS ------------------------------------ Shelly A. Saunders Vice President, Finance and Treasurer Dated: August 14, 2000 23