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INTERRENT REIT TRUST 10-K 2008
t62577_10ka.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
 


 
 
FORM 10-K/A
 
(Amendment No. 1)
 

 
 
x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2007

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: 000-31989

INTERNAP NETWORK SERVICES CORPORATION
(Exact Name of Registrant as Specified in Its Charter)

 

 
 
Delaware
 
91-2145721
(State or Other Jurisdiction of
Incorporation or Organization)
 
(I.R.S. Employer
Identification No.)
     
250 Williams Street
Atlanta, Georgia
 
30303
(Address of principal executive offices)
 
(Zip Code)

(404) 302-9700
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:

Title of Each Class
 
Name of Exchange on Which Registered
Common Stock, $0.001 par value
 
The NASDAQ Stock Market LLC
(NASDAQ Global Market)

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.     Yes   o     No   x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.     Yes   o     No   x
 

 
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   o


Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K/A or any amendment to this Form 10-K/A.   o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o
Accelerated filer x
Non-accelerated filer o
(Do not check if a smaller reporting company)
Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).     Yes   o     No   x

The aggregate market value of the registrant’s outstanding common stock held by non-affiliates of the registrant was $698,160,175 based on a closing price of $14.42 on June 30, 2007 as quoted on the NASDAQ Global Market.

As of March 6, 2008, 49,793,430 shares of the registrant’s common stock, par value $0.001 per share, were issued and outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

None.
 

 



 

EXPLANATORY NOTE>
 
Internap Network Services Corporation (the “Company” or “Internap”) is filing this Amendment No. 1 on Form 10-K/A (the “Amendment”) to amend its Annual Report on Form 10-K for the fiscal year ended December 31, 2007, originally filed on March 31, 2008 (the “Original Filing”) to set forth the information required by Items 10, 11, 12, 13, and 14 under Part III of Form 10-K because a definitive proxy statement containing such information will not be filed within 120 days after the end of the fiscal year covered by the Company’s original Form 10-K filing. This Annual Report on Form 10-K/A amends Part III of the Company’s Original Filing only, and all other portions of the Company’s Original Filing remain in effect and have not been amended to reflect events and developments since the original March 31, 2008 filing date.
 
As required by Rule 12b-15 promulgated under the Securities and Exchange Act of 1934, our Chief Executive Officer and Chief Financial Officer are providing Rule 13a-14(a) certifications dated April 30, 2008 in connection with this Amendment No. 1 on Form 10-K/A and written statements pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 dated April 30, 2008.
 
The Original Filing as amended hereby continues to speak as of the date of the Original Filing and the disclosures have not been amended to speak to any later date. Any items in the Original Filing that are not expressly amended hereby shall be as set forth in the Original Filing. The Company has included the portions of the Original Filing that are not amended by this Amendment for informational purposes only. All information contained in this Amendment and the Original Filing is subject to updating and supplementing as provided in our subsequent periodic reports filed with the Securities and Exchange Commission.
 
TABLE OF CONTENTS
 
       
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PART I
 
   
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PART II
 
   
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54
   
55
   
55
   
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PART III
 
   
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78
   
80
   
80
         
PART IV
 
   
81
   
85
 




 
 
FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K/A contains “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements include statements regarding industry trends, our future financial position and performance, business strategy, revenues and expenses in future periods, projected levels of growth, and other matters that do not relate strictly to historical facts. These statements are often identified by the use of words such as “may,” “will,” “seeks,” “anticipates,” “believes,” “estimates,” “expects,” “projects,” “forecasts,” “plans,” “intends,” “continue,” “could,” “should,” or similar expressions or variations. These statements are based on the beliefs and expectations of our management team based on information currently available. Such forward-looking statements are not guarantees of future performance and are subject to risks and uncertainties that could cause actual results to differ materially from those contemplated by forward-looking statements. Important factors currently known to our management that could cause or contribute to such differences include, but are not limited to, those set forth in this annual report under “Item 1A . Risk Factors.”  We undertake no obligation to update any forward-looking statements as a result of new information, future events or otherwise.

As used herein, except as otherwise indicated by context, references to “we,” “us,” “our,” or the “Company” refer to Internap Network Services Corporation.
 

 

PART I
 

Overview

We were incorporated as a Washington corporation in 1996 and reincorporated in Delaware in 2001. Our principal executive offices are located at 250 Williams Street, Suite E-100, Atlanta, Georgia 30303, and our telephone number at that location is (404) 302-9700. Our common stock trades on the NASDAQ Global Market under the symbol “INAP.”

We market products and services that optimize the performance and reliability of strategic business Internet applications for e-commerce, customer relationship management, or CRM, multimedia streaming, Voice-over Internet-Protocol, or VoIP, virtual private networks, or VPNs, and supply chain management. Our product and service offerings are complemented by value-added services such as colocation and data center services and managed security services. We also provide products and services for storing and delivering audio and video digital media to large audiences over the Internet through a subsidiary, VitalStream Holdings, Inc., or VitalStream. Our content delivery network, or CDN, was purpose-built for streaming digital media and enables content owners to monetize their digital media assets via both subscription and advertising-based business models. Our VitalStream subsidiary also offers: proprietary advertising selection and advertising insertion capabilities, enabling customers to turn existing streaming traffic into content packaged with advertising; Internet Protocol Television, or IPTV; professional services; and small business services. Additionally, we offer high levels of pre- and post- installation service and consulting.

As of December 31, 2007, we delivered services through our 50 service points across North America, Europe, Asia, and Australia, which feature direct high-speed connections to multiple major Internet backbones such as AT&T Inc., Sprint Nextel Corporation, Verizon Communications Inc., Savvis, Inc., Global Crossing Limited, Level 3 Communications, Inc., and Verio, an NTT Communications Company. Our proprietary route optimization technology monitors the performance of Internet networks allowing our customer traffic to be “intelligently” routed over the optimal path in a way that maximizes performance and reliability of the transactions by minimizing loss and delays inherent across the Internet. We believe our unique managed multi-network approach provides better performance, control and reliability compared to conventional Internet connectivity alternatives. Our service level agreements, or SLAs, guarantee performance across the entire Internet, excluding local connections, whereas providers of conventional Internet connectivity typically only guarantee performance on their own network. Internap serves customers in a variety of industries including financial services, entertainment and media, travel, e-commerce, retail, and technology. As of December 31, 2007, we provided our services to approximately 3,800 customers in the United States and abroad.

4

 
Developments in 2007

VitalStream Acquisition. >On February 20, 2007, we completed our acquisition of VitalStream pursuant to an Agreement and Plan of Merger, dated October 12, 2006. As a result, we issued approximately 12.2 million shares of common stock to VitalStream stockholders, which represented approximately 25% of our outstanding shares.  We also assumed outstanding options for the purchase of shares of VitalStream common stock, which we converted into options to purchase approximately 1.5 million shares of Internap common stock.  VitalStream is now a wholly-owned subsidiary of Internap.

Restructuring Liability>.   On March 31, 2007, we incurred a restructuring and impairment charge totaling $10.3 million. The charge was the result of a review of our business, particularly in light of our acquisition of VitalStream, and the finalization of our overall integration and implementation plan during the  first quarter. The charge to expense included $7.8 million for leased facilities, representing both the net present value of costs less anticipated sublease recoveries that will continue to be incurred without economic benefit to us and costs to terminate leases before the end of their term. The charge also included severance payments of $1.1 million for the termination of certain Internap employees and $1.4 million for impairment of assets. Related expenditures are estimated to be $10.7 million, of which $2.8 million has been paid during the year ended December 31, 2007, and the balance continuing through December 2016, the last date of the longest lease term. The impairment charge of $1.3 million was related to the leases referenced above and less than $0.1 million for other assets.
 
We also incurred a $1.1 million impairment recorded for a sales order-through-billing system, which was a result of an evaluation of the existing infrastructure relative to our new financial accounting system and the acquisition of VitalStream.
 
Write-Off of Investment>.  In connection with the preparation of our quarterly report for the quarter ended June 30, 2007, we wrote-off an investment, totaling $1.2 million, representing the remaining carrying value of our investment in series D preferred stock of Aventail Corporation, or Aventail. We made an initial cash investment of $6.0 million in Aventail series D preferred stock pursuant to an investment agreement in February 2000. In connection with a subsequent round of financing by Aventail, we recognized an initial impairment loss on our investment of $4.8 million in 2001. On June 12, 2007, SonicWall, Inc. announced that it had entered into an agreement to acquire Aventail for approximately $25.0 million in cash. The transaction closed on July 11, 2007, and all shares of series D preferred stock were cancelled and the holders of series D preferred stock did not receive any consideration for such shares.  Consequently, we recorded a write-off of our investment in Aventail to reduce our carrying value to $0.
 
Rights Agreement. >On March 15, 2007, the Board of Directors declared a dividend of one preferred share purchase right, or a Right, for each outstanding share of common stock, par value $0.001 per share, of the Company. The dividend was payable on March 23, 2007 to the stockholders of record on that date. Each Right entitles the registered holder to purchase from the Company one one-thousandth of a share of Series B Preferred Stock of the Company, par value $0.001 per share, or the Preferred Shares, at a price of $100.00 per one one-thousandth of a Preferred Share, subject to adjustment. The description and terms of the Rights are set forth in a Rights Agreement between the Company and American Stock Transfer & Trust Company, as Rights Agent dated April 11, 2007.
 
Data Center Expansion. >  On June 12, 2007, we announced that we approved an investment of up to $40.0 million to fund the expansion of our data center facilities in several key markets. We anticipate implementing the expansion over the next several calendar quarters, with at least a portion of the funding to be provided under our credit agreement, discussed below.  As of December 31, 2007, we have incurred costs of less than $10.0 million pursuant to this expansion.

5

 
Credit Agreement. >On September 14, 2007, we entered into a $35.0 million credit agreement. We discuss this agreement in note 10 to the consolidated financial statements and the section captioned “Liquidity and Capital Resources” under “Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations.”

Industry Background

The emergence of multiple Internet networks

The Internet originated as a restricted network designed to provide efficient and reliable long distance data communications among the disparate computer systems used by government-funded researchers and organizations. As the Internet evolved, businesses began to use the Internet for functions critical to their core business and communications. Telecommunications companies established additional networks to supplement the original public infrastructure and satisfy increasing demand. Currently, the Internet is a global collection of multitudes of interconnected computer networks, forming a network of networks. These networks were developed at great expense but are nonetheless constrained by the fundamental limitations of the Internet’s architecture. Each network must connect to one another, or peer, to permit its users to communicate with each other. Consequently, many Internet network service providers, or ISPs, have agreed to exchange large volumes of data traffic through a limited number of public network access points and a growing number of private connections called peering.

Peering network access points are not centrally managed. We believe that no single entity has the economic incentive or ability to facilitate problem resolution or to optimize peering within the public network access points, nor the authority to bring about centralized routing administration. Additionally, since these arrangements are based on non-regulated agreements, disagreements between carriers impact performance. As a consequence of the lack of coordination among networks at these public peering points, and in order to avoid the increasing congestion and the potential for resulting data loss at the public network access points, a number of the ISPs have established private interfaces connecting with their peers for the exchange of traffic. Although private peering arrangements are helpful for exchanging traffic, they do not solve all of the structural and economic shortcomings of the Internet.

The problem of inefficient routing of data traffic on the Internet

An individual ISP only controls the routing of data within its network, and its routing practices tend to compound the inefficiencies of the Internet. When an ISP receives a packet that is not destined for one of its own customers, it must route that packet to another ISP to complete the delivery of the packet on the Internet. Since the use of a public network access point or a private peering point typically involves no economic settlement, an ISP will often route the data to the nearest point of traffic exchange, in an effort to get the packet off its network and onto a competitor’s network as quickly as possible to reduce capacity and management burdens on its transport network. Once the origination traffic leaves the network of an ISP, service level agreements with that ISP typically do not apply since that carrier cannot control the quality of service on another ISPs network. Consequently, in order to complete a communication, data ordinarily passes through multiple networks and peering points without consideration for congestion or other factors that inhibit performance. For customers of conventional Internet connectivity providers, this transfer can result in lost data, slower and more erratic transmission speeds, and an overall lower quality of service, especially where the ISP is not familiar with the performance of the destination network. Equally important, these customers have no control over the transmission arrangements and have no single point of contact that they can hold accountable for degradation in service levels, such as poor data transmission performance, or service failures. As a result, it is virtually impossible for a single ISP to offer a high quality of service across disparate networks.
 
6

 
The problem of poor application performance over distant network paths

The major protocols often utilized over data networks perform poorly when network latency is large or network paths are subject to packet and data loss. Network latency is a measure of the time it takes data to travel between two network points. In networks, network latency often depends on physical distance but may also depend on conditions such as congestion. One measure of performance is effective throughput. Throughput is defined as the rate of data transfer, typically expressed in bits per second or megabits per second, or Mbps. It can be limited by the size of the network connection, for example, 1.5Mbps for a standard T1 data connection, or it can be limited by the protocols reacting to certain network conditions such as latency or packet loss. Typically, throughput is inversely proportional to network latency. Network latency is a significant factor when communicating over vast distances such as the global network paths between two continents. The more distant the communicating parties are from each other, the higher the network latency will be resulting in lower effective throughput. This throughput may be lower than the available network capacity and often results in poor utilization of purchased network capacity. Additionally, many network protocols react to packet loss by requesting a retransmission of the missing data. This retransmission is often interpreted as intermediate network congestion by the protocol that then responds with more conservative network usage and a further reduction of effective throughput. As a result, business applications that must communicate over the vast distances common in the global economy are subject to these limitations, which result in poor application performance and poor utilization of network assets. Network conditions vary significantly in many parts of the developing world and may also result in poor application performance. Yet the global economy is a factor in many businesses operating in these parts of the developing world where distances are vast and network conditions are poor.

The growing importance of the Internet for business-critical Internet-based applications

Once primarily used for e-mail and basic information retrieval, the Internet is now used as a communications platform for an increasing number of business-critical Internet-based applications, such as those relating to electronic commerce, VoIP, supply chain management, customer relationship management, project coordination, streaming media, and video conferencing and collaboration.

Businesses are unable to benefit from the full potential of the Internet primarily because of performance issues discussed above. The emergence of technologies and applications that rely on network quality and require consistent, high-speed data transfer, such as VoIP, multimedia document distribution and streaming, and audio and video conferencing and collaboration, are hindered by inconsistent performance. We believe that providers who provide a consistently high quality of service that enables businesses to successfully and cost effectively execute their business-critical Internet-based applications over the public network infrastructure through superior performance Internet routing services will drive the market for Internet services.

The growing demand for delivery of rich media content over the Internet

The proliferation of Internet-connected devices and broadband Internet connections coupled with increased consumption of media over the Internet including personalized media content have created a demand for delivery of rich media content. Increasingly, as the volume and quality of dynamic content progresses, viewers of all ages are spending more and more time using the Internet.  Viewers now expect to be able to watch a movie or television show online, view the latest news clips, take a virtual walk-through of a home, hear a podcast, watch a live sporting event or concert, or participate in an educational course just to name a few examples.  Companies that need to deliver rich media content can either deliver the content using basic Internet connectivity or utilize a content distribution network, or CDN.  Because of the inherit weaknesses of the Internet, delivery of rich media content is not reliable.  To overcome this problem, companies can either invest substantial capital to build the infrastructure to bypass the public Internet or utilize a third party’s CDN.
 
Our Market Opportunity

Historically, network service providers, or NSPs, have maintained at-will agreements to deliver Internet traffic on a “best efforts” basis without guaranteeing various levels of quality of service. This best efforts delivery is sub-optimal for time-sensitive and real-time applications that require uninterrupted streams of data such as voice and video. For companies that rely on the Internet as a medium for commerce or relationship management, this unpredictable performance often translates into lost revenue, decreased productivity and dissatisfied customers.
 
7

 
The Internet serves as a core component of many direct sales, supply chain and collaboration strategies and has extended our customers’ ability to reach global partners, suppliers and customers. This changing landscape, combined with an increasingly dispersed workforce and the adoption of emerging technologies like VoIP and streaming media, has increased the need for fast, reliable connectivity and delivery of content rich media. We believe Internap meets this requirement and is well positioned to help businesses leverage the Internet to attain improved productivity, decreased transactional costs and new revenue streams.

Services and Technology

We offer the following managed services and premise-based products:

High Performance Internet Protocol, or IP  

Our managed intelligent routing service provides fast, reliable connectivity to all major backbones and dynamically identifies the optimal path for our customers’ traffic. The service is also supported by industry leading service level agreements with 100 percent network availability, excluding local connections. Our team of certified network engineers supports our customers 24 hours a day, every day of the year. We charge for these services based on a fixed-fee, usage or a combination of both fixed fee and usage basis.

Data Center Services  

We operate data centers where customers can host their applications directly on our network to eliminate issues associated with the quality of local connections. Data center services also enable us to have a more flexible product offering, such as bundling our high performance IP connectivity and managed services such as content delivery along with hosting customers’ applications. We charge monthly fees for data center services based on the amount of square footage that the customer leases in our facilities. We also have relationships with various providers to extend our Private Network Access Point, or P-NAP, model into markets with high demand.
 

Flow Control Platform, or FCP

Our FCP is a premise-based intelligent routing hardware product for customers who run their own multiple network architectures, known as multi-homing. The prevalence of multi-homed networks is increasing. To operate each network at the highest performance level, a significant amount of expertise is required to monitor and adjust to global Internet routing, which is very dynamic in nature. The FCP functions similarly to our P-NAP, monitoring the global Internet and automatically adjusting routing real-time to balance the traffic across multiple links to optimize performance. FCP can be tuned to manage network traffic on two dimensions: cost and performance. The user can set thresholds that balance performance against cost, for example routing all traffic across low cost providers while specific minimum performance thresholds are met. If the performance deteriorates, then the traffic can be routed over a better performing but more costly provider to maintain minimum specified performance. This option allows the customer to enjoy service with the optimized performance and economics. Another key feature is minute-by-minute visibility reports and logs on the performance and operation of the customer’s network. Our customers find this information to be very useful for carrier SLA verification, monitoring and overall network management.
 
8

 
FCP is one of only a few of the industry’s route control appliances that analyzes and re-routes Internet traffic flows in real-time. We offer FCP as either a one-time hardware purchase or as a monthly subscription service. Sales of FCP also generate annual maintenance fees and professional service fees for installation and ongoing network configuration. Since the FCP emulates our P-NAP service in many ways, this product affords us the opportunity to serve customers outside of our P-NAP market footprint.

Other Products & Services

To complement our existing portfolio, we also offer managed Internet services via third parties. These services include virtual private networking and managed security services, including VeriSign, Inc. intrusion detection/prevention and managed firewall services to more broadly support our clients’ Internet applications. These also include a continuation of Akamai Technologies, Inc., or Akamai, CDN services through September 30, 2007.

We offer the following products and services based on our CDN:
 
Next Generation Cluster Architecture Content Delivery Network
 
Our CDN is designed to optimize delivery of streaming media content. The network incorporates high performance equipment with unparalleled 10 Gigabit uplinks to multiple tier-1 network providers and geographic diversity. The network is comprised of multiple data centers containing distributed server clusters. This multi-homed network helps minimize exposure at congested peers. Our close proximity to other backbone providers ensures we can quickly add bandwidth when needed. Distributed clustering technology for streaming and hosting services allows us to scale the network based on customer demand.
 
Our network is protected by advanced security systems, including firewalls, proxies and private networking to protect critical systems from intruders. We continuously monitor for security vulnerabilities and malicious activity and employ a staff of security experts to respond to security-related incidents. Additionally, we provide various encryption and digital rights management services that allow our customers to protect their content on our network.
 
Streaming Service for Flash
 
We worked hand-in-hand with Adobe, which was formerly known as Macromedia, to develop a Flash streaming platform, and are an experienced Flash video streaming service provider. This method of delivering video on demand is reliable, interactive and easy to use, giving our customers the opportunity to utilize their existing Flash development environment, and streamlining their workflow. Our Flash video streaming service permits our customers to upload files to our streaming network without having to set up and maintain video servers.
 
As an Adobe Flash Video Streaming Service provider, we can support Flash 8 and Flash Media Server 2.0. The new video features found in the Flash Platform with the announcement of Flash Player 8 offer enhanced capabilities for interactive video, enabling our customers to deliver high-quality video at the smallest file sizes while ensuring faster and smoother video playback. These enhancements significantly improve the overall viewing experience of streaming video.
 
Streaming Service for Windows Media
 
Our streaming service for windows media is ideal for businesses seeking to distribute or sell their high-quality video online with maximum control of their content. Windows Media is a flexible platform that enables content providers to protect and deliver live events, corporate presentations, news, sports, music, entertainment events, or movies with the confidence that digital media files will stay protected, no matter how they are distributed. We have been a Microsoft Premier Certified Hosting Service provider since October 2002.
 
Content Delivery Service
 
Our streaming customers often need to utilize download services as part of their business solution. In response to this customer demand, we provide file download services to enable our customers to download critical content including HTML, graphics, media files, software, and podcasts to their customers.
 
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Professional Services
 
This division assists our customers in building the unique solutions required for their specialized business models. Through internal and external resources, these services design, build and deploy custom solutions, such as video players, graphical user interfaces, or GUIs, advertising components, control panels for content management and reporting, authentication web services, and Flash Communication Server applications. These solutions are fully integrated into our CDN. We also architect, design, build, and deploy web applications that feature video or audio streaming and interface with existing customer systems. Fees for these services vary by project.
 
Authentication
 
Our authentication service provides token-based authentication services. This service protects and delivers customers’ offerings by allowing only authorized viewers to access content, which enables customers to take greater advantage of the Internet as a reliable and cost-effective distribution channel.
 
Managed Servers
 
Our managed servers are an outsourced hosting service for our customers. We provide server hardware, bandwidth and continuous system administration, including server and network monitoring, reporting, ongoing maintenance, security, and backup. We charge a fixed monthly fee for standard hosting services.
 
Advertising
 
Internap advertising services provides customers with a one-stop solution for delivering integrated streaming and digital advertising content on the Internet. The solution inserts in-stream advertisements into “live” and “on-demand” Internet streaming broadcasts to target specific listener demographics, enabling advertisers to reach the most engaged opt-in audio and video audiences with a seamless, in-stream advertising experience. Campaign management and advertising results reporting complete the comprehensive solution.
 
Network Access Points, Points of Presence and Data Centers

We provide our services through our network access points across North America, and in Europe, Asia, and Australia. Our network access points and data centers feature direct high speed connections to multiple major ISPs, including AT&T Inc., Sprint Nextel Corporation, Verizon Communications Inc., Savvis, Inc., Global Crossing Limited, Level 3 Communications, and Verio, an NTT Communications Company, as well as Internet Initiative Japan, Inc. and KDDI Corp. in Asia. Through our CDN points of presence, or POPs, we provide access to the Internet for our CDN customers. As of December 31, 2007, we provided services worldwide through 50 IP service points, 42 data center locations and 12 POPs. We directly operate eight of these sites and have operating agreements with third parties for the remaining locations in the following markets:
 
Internap operated
 
Operated under third party agreements
 
Boston
Orange County/
Amsterdam
Boston
 
Chicago
San Diego
Hong Kong
Houston
 
Dallas
Philadelphia
London
New York
 
Denver
Phoenix
Osaka(1)
Seattle
 
Los Angeles
San Francisco
Singapore
   
Miami
San Jose
Sydney
   
New York
Washington DC
Tokyo(1)
   
Oakland
 
Toronto
 

(1)
Through our joint venture in Internap Japan Co., Ltd. with NTT-ME Corporation and Nippon Telegraph and Telephone Corporation.
 
 
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We are dependent upon the ISPs noted above as well as other ISPs, telecommunications carriers and other vendors in the United States, Europe and the Asia-Pacific region, some of whom have experienced significant system failures and electrical outages in the past. Users of our services may experience difficulties due to system failures unrelated to our systems and services. If for any reason, our vendors and providers fail to provide the required services, our business, consolidated financial condition, results of operations or cash flows could be materially adversely impacted.

Segments

As discussed in note 5 to the consolidated financial statements included in this annual report on Form 10-K/A, we operate in three business segments: IP services, data center services and CDN services.

The following is a brief description of each of our reportable business segments.

IP Services
 
Our patented and patent-pending network performance optimization technologies address the inherent weaknesses of the Internet, allowing enterprises to take advantage of the convenience, flexibility and reach of the Internet to connect to customers, suppliers and partners. Our solutions take into account the unique performance requirements of each business application to ensure performance as designed, without unnecessary cost. Prior to recommending appropriate network solutions for our customers’ applications, we consider key performance objectives including (1) performance and cost optimization, (2) application control and speed and (3) delivery and reach. Our charges for IP services are based on a fixed-fee, usage or a combination of both fixed fee and usage.
 
Our IP services segment also includes our flow control platform, or FCP. The FCP provides network performance management and monitoring for companies with multi-homed networks and redundant Internet connections.  The FCP proactively reviews customer networks for the best performing route or the most cost-effective and routes according to our customers’ requirements.  We offer FCP as either a one-time hardware purchase or as a monthly subscription service. Sales of FCP also generate annual maintenance fees and professional service fees for installation and ongoing network configuration. Since the FCP emulates our private network access points, or P-NAP, service in many ways, this product affords us the opportunity to serve customers outside of our P-NAP market footprint. This product represents approximately 4% of our IP services revenue and approximately 2% of our consolidated revenue for the year ended December 31, 2007.
 
Data Center Services
 
Our data center services provide a single source for network infrastructure, IP and security, all of which are designed to maximize solution performance while providing a more stable, dependable infrastructure, and are backed by guaranteed service levels and our team of dedicated support professionals. We offer a comprehensive solution at 42 service points, including eight locations managed by us and 34 locations managed by third parties.

Data center services also enable us to have a more flexible product offering, including bundling our high performance IP connectivity and managed services, such as content delivery, along with hosting customers' applications. We charge monthly fees for data center services based on the amount of square footage that the customer leases in our facilities. We also have relationships with various providers to extend our P-NAP model into markets with high demand.
  
CDN Services
 
Our CDN services enable our customers to quickly and securely stream and distribute video, audio, advertising, and software to audiences across the globe through strategically located data centers. Providing capacity-on-demand to handle large events and unanticipated traffic spikes, content is delivered with high quality regardless of audience size or geographic location. Our MediaConsole® content management tool provides our customers the benefit of a single, easy to navigate system featuring Media Asset Management, Digital Rights Management, or DRM, support, and detailed reporting tools. With MediaConsole, our customers can use one application to manage and control access to their digital assets, deliver advertising campaigns, view network conditions, and gain insight into habits of their viewing audience.
 
11

 
Our CDN and monetization services provide a complete turnkey solution for the monetization of online media. These multi-faceted “live” and “on-demand” advertising insertion and advertising placement solutions include a full campaign management suite, inventory prediction tools, audience research and metrics, and extensive reporting features to effectively track advertising campaigns in real-time. Online advertising solutions enable our customers to offset the costs associated with the creation, transformation, licensing, and management of online content. Prior to our acquisition of VitalStream on February 20, 2007, we did not offer proprietary CDN services, but instead, we were a reseller of third party CDN services for which the results of operations are included in Other revenues and direct costs of network, sales and services, discussed below.
 
Other
 
Other revenues and direct costs of network, sales and services include our non-segmented results of operations, including certain reseller and miscellaneous services such as third party CDN services, termination fee revenue, other hardware sales, and consulting services.

Financial Information about Geographic Areas

For each of the years ended December 31, 2007, 2006 and 2005, less than 10% of our total revenues was derived from our operations outside the United States.

Sales and Marketing

Our sales and marketing objective is to achieve market penetration and increase brand recognition among business customers in key industries that use the Internet for strategic and business-critical operations. We employ a direct sales team with extensive and relevant sales experience with our target market. Our sales offices are located in key cities across North America, as well as one office each in the United Kingdom and Singapore.

Our sales and service organization includes 116 employees in direct and channel sales, professional services, account management, and technical consulting.  As of December 31, 2007, we had approximately 45 direct sales representatives whose performance is measured on the basis of achievement of quota objectives.

To support our sales efforts and promote the Internap brand, we conduct comprehensive marketing programs.  Our marketing strategies include on-line advertisements, participation at trade shows, an active public relations campaign, and continuing customer communications.  As of December 31, 2007, we had seven employees in our marketing department.

Research and Development

Product development costs are primarily related to network engineering costs associated with changes to the functionality of our proprietary services and network architecture. Such costs that do not qualify for capitalization as software development costs are expensed as incurred. Research and development costs, which are included in product development cost and are expensed as incurred, primarily consist of compensation related to our development and enhancement of IP routing technology, progressive download and streaming technology for our CDN, and acceleration technologies. Research and development costs were $3.1 million, $2.4 million and $2.9 million for the years ended December 31, 2007, 2006, and 2005, respectively. These costs do not include $1.6 million and $0.9 million in internal software development costs capitalized during the years ended December 31, 2007 and 2006, respectively. We did not capitalize any software development costs during the year ended December 31, 2005.

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Customers

As of December 31, 2007, we had approximately 3,800 customers. We provide services to customers in multiple vertical industry segments including financial services, media and communications, travel, e-commerce and retail, and technology. However, our customer base is not concentrated in any particular industry. In each of the past three fiscal years, no single customer has accounted for 10 percent or more of our net sales. No significant amounts of revenue for any of the years ended December 31, 2007, 2006 and 2005 were derived from contracts or subcontracts terminable or renegotiation at the election of the federal government, and we do not expect such contracts to be a significant percentage of our total revenue in 2008.

Competition

The market for managed services, premise-based products and content delivery is intensely competitive and is characterized by technological change, the introduction of new products and services, and price erosion. We believe that the principal factors of competition for service providers in our target markets include: speed and reliability of connectivity, quality of facilities, level of customer service and technical support, price, and brand recognition. We believe that we compete favorably on the basis of these factors.

Our current and potential competition primarily consists of:
 
 
·
network service providers that provide connectivity services, including AT&T Inc., Sprint Nextel Corporation, Verizon Communications Inc., Level 3 Communications, Inc., Global Crossing Limited, and Verio, an NTT Communications Company.;
     
 
·
regional Bell operating companies that offer Internet access and managed services;
     
 
·
global, national and regional ISPs such as Orange Business Services (formerly Equant), BT Infonet and Savvis, Inc.;
     
 
·
providers of specific applications or solutions, such as content delivery, security or storage such as Akamai Technologies, Inc., Limelight Networks, Inc., Mirror Image Internet, Inc., Symantec Corporation, Network Appliance, Inc., and Virtela Communications, Inc.;
     
 
·
software-based, Internet infrastructure companies focused on IP route control and wide area network optimization products such as Riverbed Technology, Inc., F5 Networks, Inc. and Radware Ltd.; and
     
 
·
colocation and data center providers, including Equinix, Inc., Terremark Worldwide, Inc., Navisite, Inc., 365 Main Inc., Savvis, Inc., and Neon Communications Group, Inc., formerly known as The Globix Corporation.
 
Competition has resulted, and will continue to result, in declining prices for our services.
 
Many of our competitors have longer operating histories and presence in key markets, greater name recognition, larger customer bases and significantly greater financial, sales and marketing, distribution, technical, and other resources than we have. As a result, these competitors may be able to adapt more quickly to new or emerging technologies and changes in customer requirements or to devote greater resources to the promotion and sale of their products. In all of our target markets, we also may face competition from newly established competitors, suppliers of products or services based on new or emerging technologies, and customers that choose to develop their own network solutions. We also may encounter further consolidation in the markets in which we compete. In addition, competitors may develop technologies that more effectively address our markets with services that offer enhanced features or lower costs. Increased competition could result in pricing pressures, decreased gross margins and loss of market share, which may materially and adversely affect our business, consolidated financial condition, results of operations and cash flows.
 
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Intellectual Property

We rely on a combination of copyright, patent, trademark, trade secret, and other intellectual property law, nondisclosure agreements, and other protective measures to protect our proprietary rights. We also utilize unpatented proprietary know-how and trade secrets and employ various methods to protect such intellectual property. As of December 31, 2007, we have five patents that extend to various dates between approximately 2019 and 2026, and eight registered trademarks.  Taken as a whole, we believe our intellectual property rights are significant and that the loss of all or a substantial portion of such rights could have a material adverse effect on our results of operations. We can offer no assurances that our intellectual property protection measures will be sufficient to prevent misappropriation of our technology. In addition, the laws of many foreign countries do not protect our intellectual properties to the same extent as the laws of the United States. From time to time, third parties have or may assert infringement claims against us or against our customers in connection with their use of our products or services. In addition, we may desire or be required to renew or to obtain licenses from others in order to further develop and market commercially viable products or services effectively. We can offer no assurances that any necessary licenses will be available on reasonable terms.

Employees

As of December 31, 2007, we had approximately 420 full-time employees. None of our employees are represented by a labor union, and we have not experienced any work stoppages to date. We consider the relationships with our employees to be good. Competition for technical personnel in the industry in which we compete is intense. We believe that our future success depends in part on our continued ability to hire, assimilate and retain qualified personnel. To date, we believe that we have been successful in recruiting and retaining qualified employees, but we can offer no assurances that we will continue to be successful in the future.

Other Matters

While we are dependent upon our proprietary technology and vendors, including ISPs, telecommunications carriers and others, we are not dependent upon raw materials. Our business is generally not seasonal.  We do not have significant backlog orders, nor do we have any practices relating to required working capital items.
 
Available Information

Internap files annual, quarterly and current reports, proxy statements, and other information with the Securities and Exchange Commission, or SEC. The Company makes its annual report on Form 10-K/A, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to such reports filed pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, or the Exchange Act, available free of charge on or through its Internet site, located at www.internap.com, as soon as reasonably practicable after they are filed with or furnished to the SEC. You may read and copy any materials Internap files with the SEC, at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. For information on the operation of the Public Reference Room, call the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers such as Internap that file electronically with the SEC at http://www.sec.gov. Information on the Company’s Web site is not incorporated by reference into this Form 10-K/A.
 

You should carefully consider the risks described below. These risks are not the only ones that we may face. Additional risks and uncertainties that we are unaware of, or that we currently deem immaterial, also may become important factors that affect us. If any of the following risks occurs, our business, consolidated financial condition, results of operations or cash flows could be materially and adversely affected.
 
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We have a history of losses and may not sustain profitability.
 
We incurred net losses in each quarterly and annual period since we began operations in May 1996 through the year ended December 31, 2005. For the years ended December 31, 2007, 2006 and 2005, we recognized net loss of $5.6 million, net income of $3.7 million and net loss of $5.0 million, respectively. As of December 31, 2007, our accumulated deficit was $862.0 million. Considering the competitive and evolving nature of the industry in which we operate, we may not be able to achieve or sustain profitability on a quarterly or annual basis, and our failure to do so could materially and adversely affect our business, including our ability to raise additional funds.
 
Our operations have historically been cash flow negative, and we have depended on equity and debt financings to meet our cash requirements, which may not be available to us in the future on favorable terms.
 
Historically, we have experienced negative operating cash flows and have depended upon equity and debt financings, as well as borrowings under our credit facilities, to meet our cash requirements in most quarterly and annual periods since we began our operations in May 1996. We expect to meet our cash requirements for 2008 through a combination of cash flows from operations, existing cash, cash equivalents and investments in marketable securities, and borrowings under our credit facilities. Our capital requirements depend on several factors, including the rate of market acceptance of our services, the ability to expand and retain our customer base and other factors. If our cash requirements vary materially from those currently planned, if our cost reduction initiatives are unsuccessful or have unanticipated adverse effects on our business or if we fail to generate sufficient cash flows from the sales of our services, we may require additional financing sooner than anticipated. We can offer no assurances that we will be able to obtain additional financing on commercially favorable terms, or at all. In addition, provisions in our credit agreement limit our ability to incur additional indebtedness.  Our business could be materially and adversely affected by our failure to obtain such funding.  We might also be required to take other actions that could lessen the value of our stock in order to obtain such funding, such as issuing securities with greater rights than our common stock or borrowing money on terms that are not favorable to us.
 
We have identified a material weakness in our internal control over financial reporting that may prevent us from accurately reporting our financial results in a timely manner.
 
We must maintain effective internal controls in order to provide reliable and accurate financial reports and prevent fraud. In addition, Section 404 of the Sarbanes-Oxley Act of 2002 requires that we assess the design and operating effectiveness of our internal control over financial reporting. In connection with our evaluation of internal control over financial reporting, we identified a material weakness related to effective controls over the analysis of requests for sales credits and billing adjustments to provide timely information for management to assess the completeness, accuracy, valuation and disclosure of sales adjustments. We may also discover additional areas of our internal controls that need improvement. We discuss our efforts regarding internal controls in detail in this report under Item 9A, “Controls and Procedures.” We cannot be certain that any remedial measures we take will sufficiently address and eliminate this material weakness. Remedying this material weakness, any additional deficiencies, significant deficiencies, or material weaknesses that we may identify in the future, could require us to incur significant costs, expend significant time and management resources or make other changes. We have not yet remediated this material weakness. As a result, we may be required to report in our Quarterly Report on Form 10-Q for the first quarter of 2008 or in subsequent reports filed with the Securities and Exchange Commission that a material weakness in our internal control over financial reporting continues to exist. Any delay or failure to design and implement new or improved controls, or difficulties encountered in their implementation or operation may cause us to fail to meet our financial reporting obligations or prevent us from providing reliable and accurate financial reports or avoiding or detecting fraud. Disclosure of this material weakness, any failure to remediate such material weakness in a timely fashion or having or maintaining ineffective internal controls could cause investors to lose confidence in our reported financial information.
 
We may not be able to compete successfully against current and future competitors.
 
The Internet connectivity and IP services market is highly competitive, as evidenced by recent declines in pricing for Internet connectivity services. The content delivery market is also intensely competitive and rapidly changing.  We expect competition from existing competitors to continue to intensify in the future, and we may not have the financial resources, technical expertise, sales and marketing abilities, or support capabilities to compete successfully. Our competitors currently include: regional Bell operating companies that offer Internet access; global, national and regional ISPs; providers of specific applications or solutions such as content delivery, security or storage; software-based and other Internet infrastructure providers and manufacturers; and colocation and data center providers. In addition, ISPs may make technological advancements, such as the introduction of improved routing protocols to enhance the quality of their services, which could negatively impact the demand for our products and services.
 
In addition, we will face additional competition as we expand our managed services product offerings, including competition from technology and telecommunications companies. A number of telecommunications companies and ISPs have offered or expanded their network services. Further, the ability of some of these potential competitors to bundle other services and products with their network services could place us at a competitive disadvantage. Various companies also are exploring the possibility of providing, or are currently providing, high-speed, intelligent data services that use connections to more than one network or use alternative delivery methods including the cable television infrastructure, direct broadcast satellites and wireless local loop. Many of our existing and future competitors may have greater market presence, engineering and marketing capabilities, and financial, technological and personnel resources than we have. As a result, our competitors may have significant advantages over us and may be able to respond more quickly to emerging technologies and ensuing customer demands. Increased competition and technological advancements by our competitors could materially and adversely affect our business, consolidated financial condition, results of operations and cash flows.
 
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In addition, more and more businesses are deciding to develop their own solutions rather than outsource such solutions to providers like us.  If we are unable to provide services that are competitive with such in-sourced solutions, we will lose customers and our business and financial results will suffer.
 
Failure to develop new products and services, as well as enhancements to our existing services, may cause our operating results to suffer>.
 
Our industry is constantly evolving.  The process of developing new services and the technologies that support them is expensive, time and labor intensive and uncertain.  We may fail to understand the market demand for new services or not be able to overcome technical problems with new services.  In addition, our customers’ needs may change in ways that we do not anticipate and these changes could eliminate our customers’ needs for our services and render our products and services obsolete. If we fail to develop new products and services before our competitors, we may lose market share, resulting in a decrease in our revenues and earnings.
 
Many of our current and potential customers are pursuing emerging or unproven business models and the demand for our services and products may decline if such models are unsuccessful.
 
The need for a content delivery network is a recent technological advancement and our customers’ business models that rely on the delivery of streaming video and other content remain unproven.  These customers will not continue to purchase our products and services if their investment does not generate a sufficient return.  A reduction in spending on CDN services by such customers could materially and adversely affect our financial condition.
 
Pricing pressure could decrease our revenue and threaten the attractiveness of our premium priced services.
 
Pricing for Internet connectivity services has declined significantly in recent years and may decline in the future. An economic downturn could further contribute to this effect. We currently charge, and expect to continue to charge, higher prices for our high performance IP services than prices charged by our competitors for their connectivity services. By bundling their services and reducing the overall cost of their solutions, certain of our competitors may be able to provide customers with reduced communications costs in connection with their Internet connectivity services or private network services, thereby significantly increasing the pressure on us to decrease our prices. Increased price competition, significant price deflation and other related competitive pressures could erode our revenue and could materially and adversely affect our results of operations if we are unable to control or reduce our costs. Because we rely on ISPs to deliver our services and have agreed with some of these providers to purchase minimum amounts of service at predetermined prices, our profitability could be adversely affected by competitive price reductions to our customers even if accompanied with an increased number of customers.
 
In addition, in light of economic factors and technological advances, companies that require Internet connectivity have evaluated and will continue to evaluate the cost of such services, particularly high performance connectivity services such as those we currently offer. Consequently, existing and potential customers may be less willing to pay premium prices for high performance Internet connectivity services and may choose to purchase lower quality services at lower prices, which could materially and adversely affect our business, consolidated financial condition, results of operations and cash flows.

Failure to increase our revenues may cause our business and financial results to suffer.

We have considerable fixed expenses and we plan to continue to incur significant expenses with the expansion of our colocation facilities.  We must, therefore, generate higher revenues to maintain profitability.  Numerous factors could affect our ability to increase revenue, either alone or in combination with other factors, including:
     
 
·  
failure to increase sales of our products and services;
     
 
·  
pricing pressures;
     
 
·  
failure of our services or software to operate as expected;
     
 
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·  
loss of customers and inability to attract new customers;
     
 
·  
inability of a customer to pay our fees; or
     
 
·  
network failures and any breach or unauthorized access to our network.

We depend on a number of ISPs to provide Internet connectivity to our network access points. If we are unable to obtain required connectivity services on a cost-effective basis, or at all, or if such services are interrupted or terminated, our growth prospects and business, consolidated financial condition, results of operations and cash flows may be adversely affected.
 
In delivering our services, we rely on a number of Internet networks, many of which are built and operated by others. In order to provide high performance connectivity services to our customers through our network access points, we purchase connections from several ISPs. We can offer no assurances that these ISPs will continue to provide service to us on a cost-effective basis or on otherwise competitive terms, if at all, or that these providers will provide us with additional capacity to adequately meet customer demand or to expand our business. Consolidation among ISPs limits the number of vendors from which we obtain service, possibly resulting in higher network costs to us. We may be unable to establish and maintain relationships with other ISPs that may emerge or that are significant in geographic areas, such as Asia and Europe, in which we may locate our future network access points. Any of these situations could limit our growth prospects and materially and adversely affect our business, consolidated financial condition, results of operations and cash flows.

We depend on third party suppliers for services and key elements of our network infrastructure. If we are unable to obtain products or services, such as network access loops or local loops, on favorable terms, or at all, or in the event of a failure of these suppliers to deliver their products and services as agreed, our ability to provide our services on a competitive and timely basis may be impaired and our consolidated financial condition, results of operations and cash flows could be adversely affected.
 
In addition to depending on services from third party ISPs, we depend on other companies to supply various key elements of our infrastructure, including the network access loops between our network access points and our ISPs and the local loops between our network access points and our customers’ networks. Pricing for such network access loops and local loops has risen significantly over time, and we generally bill these charges to our customers at low or no margin. Some of our competitors have their own network access loops and local loops and are, therefore, not subject to similar availability and pricing issues. In addition, we currently purchase routers and switches from a limited number of vendors. Furthermore, we do not carry significant inventories of the products we purchase, and we have no guaranteed supply arrangements with our vendors. A loss of a significant vendor could delay any build-out of our infrastructure and increase our costs. If our limited source of suppliers fails to provide products or services that comply with evolving Internet standards or that interoperate with other products or services we use in our network infrastructure, we may be unable to meet all or a portion of our customer service commitments, which could materially and adversely affect our business, consolidated financial condition, results of operations and cash flows.
   
A failure in the redundancies in our network operations centers, network access points or computer systems could cause a significant disruption in our IP services, and we may experience significant disruptions in our ability to service our customers.
 
Our business depends on the efficient and uninterrupted operation of our network operations centers, our network access points and our computer and communications hardware systems and infrastructure. Interruptions could result from natural or human-caused disasters, power loss, telecommunications failure, and similar events. If we experience a problem at our network operations centers, including the failure of redundant systems, we may be unable to provide IP services to our customers, provide customer service and support or monitor our network infrastructure or network access points, any of which would seriously harm our business and operating results. Also, because we provide continuous Internet availability under our service level agreements, we may be required to issue a significant amount of customer credits as a result of such interruptions in service. These credits could negatively affect our revenues and results of operations. In addition, interruptions in service to our customers could harm our customer relations, expose us to potential lawsuits and require additional capital expenditures.
 
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A significant number of our network access points are located in facilities owned and operated by third parties. In many of those arrangements, we do not have property rights similar to those customarily possessed by a lessee or subtenant but instead have lesser rights of occupancy. In certain situations, the financial condition of those parties providing occupancy to us could have an adverse impact on the continued occupancy arrangement or the level of service delivered to us under such arrangements.
 
The increased use of high power density equipment may limit our ability to fully utilize our data centers.
 
Customers continue to increase their use of high-density equipment, such as blade servers, in our data centers, which has significantly increased the demand for power on a per cabinet basis. The current demand for electrical power may exceed our designed capacity in these facilities. As electrical power, not space, is typically the primary factor limiting capacity in our data centers, our ability to fully utilize our data centers may be limited in these facilities.  If we are unable to adequately utilize our data centers, our ability to grow our business cost-effectively could be materially and adversely affected.

Our business could be harmed by prolonged electrical power outages or shortages, increased costs of energy or general availability of electrical resources.

Our data centers and P-NAPs are susceptible to regional costs of power, electrical power shortages, planned or unplanned power outages or natural disasters, and limitations, especially internationally, on availability of adequate power resources. Power outages could harm our customers and our business. We attempt to limit exposure to system downtime by using backup generators and uninterruptible power systems. We may not be able to limit our exposure entirely, however, even with these protections in place, as has been the case with power outages we have experienced in the past and may experience in the future. In addition, we may not be able to pass on to our customers the increased cost of energy caused by power shortages.
 
In each of our markets, we rely on utility companies to provide a sufficient amount of power for current and future customers. At the same time, power and cooling requirements are growing on a per unit basis. As a result, some customers are consuming an increasing amount of power per cabinet. We do not have long-term power agreements in all our markets for long-term guarantees of provisioned amounts and may face power limitations in our centers. This limitation could have a negative impact on the effective available capacity of a given center and limit our ability to grow our business, which could have a negative impact on our consolidated financial condition, results of operations and cash flows.
Any failure of our physical infrastructure or services could lead to significant costs and disruptions that could reduce our revenue and harm our business reputation, consolidated financial condition, results of operations and cash flows.

Our business depends on providing customers with highly reliable service. We must protect our infrastructure and our customers’ data and their equipment located in our data centers. The services we provide in each of our data centers are subject to failure resulting from numerous factors, including:
       
 
·  
human error;
 
   
 
·  
physical or electronic security breaches;
 
   
 
·  
fire, earthquake, flood, and other natural disasters;
 
   
 
·
water damage;
 
   
 
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·
fiber cuts;
 
   
 
·
power loss;
 
   
 
·
sabotage and vandalism; and
 
   
 
·
failure of business partners who provide our resale products.
 

Problems at one or more of the data centers operated by us or any of our colocation providers, whether or not within our control, could result in service interruptions or significant equipment damage, which could result in difficulty maintaining our service level commitments to these customers. If we incur significant financial commitments to our customers in connection with a loss of power or we fail to meet other service level commitment obligations, our revenue reserves may not be adequate. In addition, any loss of services, equipment damage or inability to meet our service level commitment obligations could reduce the confidence of our customers and could consequently impair our ability to obtain and retain customers, which would adversely affect both our ability to generate revenues and our operating results.

Furthermore, we are dependent upon ISPs and telecommunications carriers in the United States, Europe and the Asia-Pacific region, some of whom have experienced significant system failures and electrical outages in the past. Users of our services may experience difficulties due to system failures unrelated to our systems and services. If for any reason, these providers fail to provide the required services, our business, consolidated financial condition, results of operations and cash flows could be materially adversely impacted.

No prevention or defense against denial of service attacks exists. During a prolonged denial of service attack, Internet service may not be available for several hours, thus negatively impacting hosted customers’ on-line business transactions. Affected customers might file claims against us under such circumstances, and our property and liability insurance may not be adequate to cover these claims.

Our results of operations have fluctuated in the past and may continue to fluctuate, which could have a negative impact on the price of our common stock.
 
We have experienced fluctuations in our results of operations on a quarterly and annual basis. The fluctuation in our operating results may cause the market price of our common stock to decline. We expect to experience significant fluctuations in our operating results in the foreseeable future due to a variety of factors, including:
       
 
·
competition and the introduction of new services by our competitors;
 
   
 
·
continued pricing pressures resulting from competitors’ strategies or excess bandwidth supply;
 
   
 
·
fluctuations in the demand and sales cycle for our services;
 
   
 
·
fluctuations in the market for qualified sales and other personnel;
 
   
 
·
changes in the prices for Internet connectivity we pay to ISPs;
 
   
 
·
the cost and availability of adequate public utilities, including power;
 
   
 
·
our ability to obtain local loop connections to our network access points at favorable prices;
 
   
 
·
integration of people, operations, products, and technologies of acquired businesses; and
 
   
 
·
general economic conditions.
 
 
 
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In addition, fluctuations in our results of operations may arise from strategic decisions we have made or may make with respect to the timing and magnitude of capital expenditures such as those associated with the expansion of our colocation facilities, the deployment of additional network access points and the terms of our network connectivity purchase agreements. These and other factors discussed in this annual report on Form 10-K/A could have a material adverse effect on our business, consolidated financial condition, results of operations and cash flows. In addition, a relatively large portion of our expenses are fixed in the short-term, particularly with respect to lease and personnel expense, depreciation and amortization and interest expense. Our results of operations, therefore, are particularly sensitive to fluctuations in revenue. Because our results of operations have fluctuated in the past and are expected to continue to fluctuate in the future, we can offer no assurance that the results of any particular period are an indication of future performance in our business operations. Fluctuations in our results of operations could have a negative impact on our ability to raise additional capital and execute our business plan. Our operating results in one or more future quarters may fail to meet the expectations of securities analysts or investors, which could cause an immediate and significant decline in the trading price of our stock.

We have acquired and may acquire other businesses, and these acquisitions involve numerous risks.
 
We may pursue acquisitions of complementary businesses, products, services, and technologies to expand our geographic footprint, enhance our existing services, expand our service offerings, and enlarge our customer base. If we complete future acquisitions, we may be required to incur or assume additional debt, make capital expenditures or issue additional shares of our common stock or securities convertible into our common stock as consideration, which would dilute our existing stockholders’ ownership interest and may adversely affect our results of operations. Our ability to grow through acquisitions involves a number of additional risks, including the following:
 
 
·  
the ability to identify and consummate complementary acquisitions;
 
   
 
·
the possibility that we may not be able to integrate the operations, personnel, technologies, products, and services of the acquired companies in a timely and efficient manner;
 
   
 
·
diversion of management’s attention from other ongoing business concerns;
 
       
 
·
insufficient revenue to offset significant unforeseen costs and increased expenses associated with the acquisitions;
 
   
 
·
challenges in completing projects associated with in-process research and development being conducted by the acquired businesses;
 
   
 
·
risks associated with our entrance into markets in which we have little or no prior experience and where competitors have a stronger market presence;
 
   
 
·
deferral of purchasing decisions by current and potential customers as they evaluate the likelihood of success of our acquisitions;
 
   
 
·
incurring or assuming contingent liabilities and amortization expense for acquired intangible assets;
 
   
 
·
incurring acquisition liabilities as a result of integrating acquired businesses;
 
       
 
·
difficulties in successfully integrating the management teams and employees of both companies; and
 
   
 
·
loss of key employees of the acquired companies.
 
 
Failure to effectively manage our growth through acquisitions could adversely affect our growth prospects, business, consolidated financial condition, results of operations and cash flows.

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The terms of our existing credit agreement impose restrictions upon us.
 
The terms of our existing credit agreement impose operating and financial restrictions on us and require us to meet certain financial tests. These restrictions may also have a negative impact on our business, consolidated financial condition, results of operations and cash flows by significantly limiting or prohibiting us from engaging in certain transactions. The credit agreement contains certain covenants, including covenants that restrict our ability to incur further indebtedness.
 
The failure to comply with any of these covenants would cause a default under the credit agreement. Any defaults, if not waived, could result in the lender ceasing to make loans or extending credit to us, accelerating or declaring all or any obligations immediately due, or taking possession of or liquidating collateral. If any of these events occur, we may not be able to borrow sufficient funds to refinance the credit agreement on terms that are acceptable to us, which could materially and adversely impact our business, consolidated financial condition, results of operations and cash flows.
 
As of December 31, 2007, we were in compliance with the various loan covenants required by the credit agreement.
 
Our investments in auction rate securities are subject to risks that may cause losses and affect the liquidity of these investments.
 
As of December 31, 2007, we held $7.2 million of auction rate securities classified as short-term investments. Auction rate securities are variable rate bonds tied to short-term interest rates with maturities on the face of the securities in excess of 90 days and have interest rate resets through a modified Dutch auction, at predetermined short-term intervals, usually every 7, 28 or 35 days.  Although these securities are issued and rated as long term bonds, they are priced and traded as short-term instruments because of the liquidity provided through the interest rate resets.  The underlying assets of our auction rate securities are state-issued student and educational loans that are substantially backed by the federal government and carried AAA/Aaa ratings as of December 31, 2007.  The Dutch auctions have in the past provided a liquid market for these types of securities. With the liquidity issues experienced in global credit and capital markets, auctions of each of the auction rate securities that we hold failed subsequent to December 31, 2007, as the amount of securities submitted for sale exceeded the amount of purchase orders. If the uncertainties in the credit and capital market continue, these markets deteriorate further or the various rating agencies downgrade any of the auction rare securities that we hold, we may be required to adjust the value of these investments through an impairment charge to earnings if the fair value of these securities has declined to below their cost and such decline is assessed to be “other than temporary” under SFAS No. 115. Further, we may not be able to liquidate these investments until successful auctions occur, a buyer outside the auction process is found, the issuer calls these debt securities, or the securities mature.
 
Continued overcapacity in the Internet connectivity and IP services market may result in our recording additional significant restructuring charges and goodwill impairment.

We have undertaken significant operational restructurings and have taken restructuring and impairment charges and recorded total restructuring costs of $11.3 million for the year ended December 31, 2007 and less than $1.0 million for the years ended December 31, 2006 and 2005. We may incur additional restructuring charges or adjustments in the future. Such additional restructuring charges or adjustments could materially and adversely affect our business, net profit and stockholders’ equity.

Adverse experience in the CDN services market may result in our recording additional goodwill impairment charges.

Upon completion of our acquisition of VitalStream, we recorded $154.8 million in goodwill.  We tested this goodwill in August of 2007 as part of our annual testing, and concluded that such goodwill had not been impaired.  We can offer no assurances, however, that this goodwill will remain unimpaired.  We may incur impairment charges in the future, which could materially and adversely affect our net profit and stockholders’ equity.

21

 
If we are unable to deploy new network access points or do not adequately control expense associated with the deployment of new network access points, our results of operations could be adversely affected.

As part of our strategy, we intend to continue to expand our network access points, particularly into new geographic markets. We will face various risks associated with identifying, obtaining and integrating attractive network access point sites, negotiating leases for centers on competitive terms, cost estimation errors or overruns, delays in connecting with local exchanges, equipment and material delays or shortages, the inability to obtain necessary permits on a timely basis, if at all, and other factors, many of which are beyond our control and all of which could delay the deployment of a new network access point. We can offer no assurance that we will be able to open and operate new network access points on a timely or profitable basis. Deployment of new network access points will increase operating expense, including expense associated with hiring, training, retaining, and managing new employees, provisioning capacity from ISPs, purchasing new equipment, implementing new systems, leasing additional real estate, and incurring additional depreciation expense. If we are unable to control our costs as we expand in geographically dispersed locations, our consolidated financial condition, results of operations and cash flows could be materially and adversely affected.
 
Our international operations may not be successful.

We have limited experience operating internationally and have only recently begun to achieve successful international experiences. We currently have network access points in London, England, Hong Kong, Singapore, and Sydney, Australia. We also participate in a joint venture with NTT-ME Corporation and Nippon Telegraph and Telephone Corporation, or NTT Holdings, that operates a network access point in Tokyo and Osaka, Japan and maintain a marketing agreement with Telefonica USA, which provides us with further access in Europe and access to the Latin American market. As part of our strategy to expand our geographic markets, we may develop or acquire network access points or complementary businesses in additional international markets. The risks associated with expansion of our international business operations include:
 
 
·
challenges in establishing and maintaining relationships with foreign customers as well as foreign ISPs and local vendors, including data center and local network operators;
 
   
 
·
challenges in staffing and managing network operations centers and network access points across disparate geographic areas;
 
   
 
·
limited protection for intellectual property rights in some countries;
 
   
 
·
challenges in reducing operating expense or other costs required by local laws;
 
   
 
·
exposure to fluctuations in foreign currency exchange rates;
 
       
 
·
costs of customizing network access points for foreign countries and customers;
 
   
 
·
protectionist laws and practices favoring local competition;
 
   
 
·
political and economic instability; and
 
       
 
·
compliance with governmental regulations.
 
 
We may be unsuccessful in our efforts to address the risks associated with our international operations, which may limit our international sales growth and materially and adversely affect our business and results of operations.
 
22

 
Disputes with vendors regarding the delivery of services may materially impact our results of operations and cash flows.
 
In delivering our services, we rely on a number of Internet network, telecommunication and other vendors. We work directly with these vendors to provide services such as establishing, modifying or discontinuing services for our customers. Because of the volume of activity, billing disputes inevitably arise. These disputes typically stem from disagreements concerning the starting and ending dates of service, quoted rates, usage, and various other factors. We research and discuss disputed costs, both in the vendors’ favor and our favor, with vendors on an ongoing basis until ultimately resolved. We record the cost and a liability based on our estimate of the most likely outcome of the dispute. These estimates are periodically reviewed by management and modified in light of new information or developments, if any. Because estimates regarding disputed costs include assessments of uncertain outcomes, such estimates are inherently vulnerable to changes due to unforeseen circumstances that could materially and adversely affect our consolidated financial condition, results of operations and cash flows.
 
We depend upon our key employees and may be unable to attract or retain sufficient numbers of qualified personnel.
 
Our future performance depends to a significant degree upon the continued contributions of our executive management team and other key employees. To the extent we are able to expand our operations and deploy additional network access points, we may need to increase our workforce. Accordingly, our future success depends on our ability to attract, hire, train, and retain highly skilled management, technical, sales, marketing, and customer support personnel. Competition for qualified employees is intense, and we compete for qualified employees with companies that may have greater financial resources than we have. Our employment security plan with our executive officers provide that either party may terminate their employment at any time. Consequently, we may not be successful in attracting, hiring, training, and retaining the people we need, which would seriously impede our ability to implement our business strategy.

Our senior management team has had limited time to develop a working relationship with each other and may not be able to manage our business effectively.

Our Chief Operating Officer, General Counsel, Chief Technology Officer, and Chief Strategy Officer have been hired since March 2007, and we are currently seeking a Chief Financial Officer.  This limited experience working together could harm our management team’s ability to quickly and efficiently respond to problems and effectively manage our business.
 
If we fail to adequately protect our intellectual property, we may lose rights to some of our most valuable assets.
 
We rely on a combination of copyright, patent, trademark, trade secret, and other intellectual property law, nondisclosure agreements, and other protective measures to protect our proprietary rights. We also utilize unpatented proprietary know-how and trade secrets and employ various methods to protect such intellectual property. Taken as a whole, we believe our intellectual property rights are significant and that the loss of all or a substantial portion of such rights could have a material adverse effect on our results of operations. We can offer no assurance that our intellectual property protection measures will be sufficient to prevent misappropriation of our technology. In addition, the laws of many foreign countries do not protect our intellectual property to the same extent as the laws of the United States. From time to time, third parties have or may assert infringement claims against us or against our customers in connection with their use of our products or services.

In addition, we rely on the intellectual property of others. We may desire or be required to renew or to obtain licenses from these other parties in order to further develop and market commercially viable products or services effectively. We can offer no assurance that any necessary licenses will be available on reasonable terms.
 
We may face litigation and liability due to claims of infringement of third party intellectual property rights.
 
The Internet services industry is characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement. From time to time, third parties may assert patent, copyright, trademark, trade secret, and other intellectual property rights to technologies that are important to our business. Any claims that our products or services infringe or may infringe proprietary rights of third parties, with or without merit, could be time-consuming, result in costly litigation, divert the efforts of our technical and management personnel, or require us to enter into royalty or licensing agreements, any of which could significantly harm our operating results. In addition, our customer agreements generally provide for us to indemnify our customers for expenses and liabilities resulting from claimed infringement of patents or copyrights of third parties, subject to certain limitations. If an infringement claim against us were to be successful, and we were not able to obtain a license to the relevant technology or a substitute technology on acceptable terms or redesign our products or services to avoid infringement, our ability to compete successfully in our competitive market would be materially impaired.

23

 
We may become involved in other litigation that may adversely affect us.

In the ordinary course of business, we are or may become involved in litigation, administrative proceedings and governmental proceedings.  Such matters can be time-consuming, divert management’s attention and resources and cause us to incur significant expenses.  Furthermore, the results of any such actions could have a material adverse effect on our business, consolidated financial condition, results of operations or cash flows.
Risks Related to Our Industry

We cannot predict with certainty the future evolution of the high performance Internet connectivity market, and therefore the role of our products and services.
 
We face the risk that the market for high performance Internet connectivity services might develop more slowly or differently than currently projected, or that our services may not achieve continued widespread market acceptance. Furthermore, we may be unable to market and sell our services successfully and cost-effectively to a sufficiently large number of customers. We typically charge a premium for our services, which may affect market acceptance of our services or adversely impact the rate of market acceptance. We believe the danger of non-acceptance is particularly acute during economic slowdowns, which exert significant pricing pressure on ISPs. If the Internet becomes subject to a form of central management, or if ISPs establish an economic settlement arrangement regarding the exchange of traffic between Internet networks, the demand for our IP services could be materially and adversely affected.
 
If we are unable to respond effectively and on a timely basis to rapid technological change, we may lose or fail to establish a competitive advantage in our market.
 
Our industry is characterized by rapidly changing technology, industry standards and customer needs, as well as by frequent new product and service introductions. New technologies and industry standards have the potential to replace or provide lower cost alternatives to our services. The adoption of such new technologies or industry standards could render our existing services obsolete and unmarketable. Our failure to anticipate the prevailing standard, to adapt our technology to any changes in the prevailing standard or the failure of a common standard to emerge could materially and adversely affect our business. Our pursuit of necessary technological advances may require substantial time and expense, and we may be unable to successfully adapt our network and services to alternative access devices and technologies.

Our network and software are subject to potential security breaches and similar threats that could result in our liability for damages and harm our reputation.
 
A number of widespread and disabling attacks on public and private networks have occurred recently. The number and severity of these attacks may increase in the future as network assailants take advantage of outdated software, security breaches or incompatibility between or among networks. Computer viruses, intrusions and similar disruptive problems could cause us to be liable for damages under agreements with our customers, and our reputation could suffer, thereby deterring potential customers from working with us. Security problems or other attacks caused by third parties could lead to interruptions and delays, or to the cessation of service to our customers. Furthermore, inappropriate use of the network by third parties could also jeopardize the security of confidential information stored in our computer systems and in those of our customers and could expose us to liability under unsolicited commercial e-mail, or “spam,” regulations. In the past, third parties have occasionally circumvented some of these industry-standard measures. We can offer no assurance that the measures we implement will not be circumvented. Our efforts to eliminate computer viruses and alleviate other security problems, or any circumvention of those efforts, may result in increased costs, interruptions, delays or cessation of service to our customers, which could hurt our business, consolidated financial condition, results of operations and cash flows.

24

 
Terrorist activity throughout the world and military action to counter terrorism could adversely impact our business.
 
The continued threat of terrorist activity and other acts of war or hostility may have an adverse effect on business, financial and general economic conditions internationally. Effects from any future terrorist activity, including cyber terrorism, may, in turn, increase our costs due to the need to provide enhanced security, which would adversely affect our business, consolidated financial condition, results of operations and cash flows. These circumstances may also damage or destroy the Internet infrastructure and may materially and adversely affect our ability to attract and retain customers, our ability to raise capital and the operation and maintenance of our network access points.

If governments modify or increase regulation of the Internet, the provision of our services could become more costly.
 
International bodies and federal, state and local governments have adopted a number of laws and regulations that affect the Internet and are likely to continue to seek to implement additional laws and regulations. For example, a federal law regulating spam was enacted in 2003. In addition, federal and state agencies are actively considering regulation of various aspects of the Internet, including taxation of transactions, and imposing access fees for voice over IP, or VoIP. The Federal Communications Commission and state agencies also review the regulatory requirements, if any, that should be applicable to VoIP. If we seek to offer additional products and services, we could be required to obtain certain, additional authorizations from regulatory agencies. We may not be able to obtain such authorizations in a timely manner, or at all, and conditions could be imposed upon such authorization that may not be favorable to us.
 
Congress recently extended the Internet Tax Freedom Act, which placed a moratorium against certain state and local taxation of Internet access, until November 1, 2014. Pursuant to this moratorium, most of our services are not subject to state and local taxation.  
In addition, laws relating to the liability of private network operators and information carried on or disseminated through their networks are unsettled, both in the United States and abroad.  Network operators have been sued in the past based on the content of material disseminated through their networks.  We may become subject to legal claims such as defamation, invasion of privacy and copyright infringement in connection with content stored on or distributed through our network.  Also, our reputation could suffer as a result of our perceived association with the type of content that some of our customers deliver.

The adoption of any future laws or regulations might decrease the growth of the Internet, decrease demand for our services, impose taxes or other costly technical requirements, regulate the Internet similar to the regulation of traditional telecommunications services, or otherwise increase the cost of doing business on the Internet in some other manner. Any of these actions could have a significantly harmful effect on our customers or us. Moreover, the nature of any new laws and regulations and the interpretation of applicability to the Internet of existing laws governing intellectual property ownership and infringement, copyright, trademark, trade secret, obscenity, libel, employment, personal privacy, and other issues is uncertain and developing. We cannot predict the impact, if any, that future regulation or regulatory changes may have on our business.

If our ability to deliver media files in certain formats is restricted or becomes cost-prohibitive, demand for our services would decline and our financial results would suffer.

Our CDN products and services depend on our ability to deliver media content in all major formats.  If our legal right to store and deliver content in certain formats, like Adobe Flash or Windows Media, for example, was limited, we could not serve our customers and the demand for our services would decline.  Owners of proprietary content formats may be able to block, restrict or impose fees or other costs on our use of such formats, leading to additional expenses or prevent our delivery of this type of content, which could materially and adversely affect our operating results.
 
25

 
Risks Related to Our Capital Stock
 
Our common stockholders may experience significant dilution, which could depress the market price of our common stock.
 
Holders of our stock options and warrants to purchase common stock may exercise their options or warrants to purchase our common stock, which would increase the number of outstanding shares of common stock in the future. As of December 31, 2007, options to purchase an aggregate of 3.2 million shares of our common stock at a weighted average exercise price of $13.29 were outstanding, and warrants to purchase approximately 34,000 shares of our common stock at an exercise price of $9.50 per share were outstanding. Also, the vesting of 0.7 million outstanding restricted stock awards will increase the weighted average number of shares used for calculating diluted net income per share. We issued approximately 12.2 million shares of our common stock to VitalStream’s stockholders in connection with the acquisition in February of 2007. We also assumed outstanding options for the purchase of shares of VitalStream common stock, converted into options to purchase approximately 1.5 million shares of Internap common stock. Furthermore, greater than expected capital requirements could require us to obtain additional financing through the issuance of securities, which could be in the form of common stock or preferred stock or other securities having greater rights than our common stock. The issuance of our common stock or other securities, whether upon the exercise of options and warrants, the future vesting and issuance of stock awards to our executives and employees, or in financing transactions, could depress the market price of the common stock by increasing the number of shares of common stock or other securities outstanding on an absolute basis or as a result of the timing of additional shares of common stock becoming available on the market.

Provisions of our charter documents, our stockholder rights plan and Delaware law may have anti-takeover effects that could prevent a change in control even if the change in control would be beneficial to our stockholders.

Provisions of our certificate of incorporation, as amended, amended and restated bylaws and Delaware law could make an acquisition more difficult, even if doing so would be beneficial to our stockholders.  In addition, our Board of Directors recently adopted a stockholder rights plan that renders the consummation of an acquisition without the approval of the Board of Directors more difficult.
 
Our stock price may be volatile.
 
The market for our equity securities has been extremely volatile. Our stock price could suffer in the future as a result of any failure to meet the expectations of public market analysts and investors about our results of operations from quarter to quarter. The following factors could cause the price of our common stock in the public market to fluctuate significantly:

 
·  
actual or anticipated variations in our quarterly and annual results of operations;
 
   
 
·
changes in market valuations of companies in the Internet connectivity and services industry;
 
   
 
·  
changes in expectations of future financial performance or changes in estimates of securities analysts;
 
   
 
·
fluctuations in stock market prices and volumes;
 
   
 
 
26

 
 
·  
future issuances of common stock or other securities;
 
   
 
·  
the addition or departure of key personnel; and
 
   
 
·  
announcements by us or our competitors of acquisitions, investments or strategic alliances.
 

Changes in financial accounting standards may adversely affect our reported results of operations.

New accounting pronouncements and interpretations have occurred and may occur in the future that adversely affect on our reported results.  For example, Statement of Financial Accounting Standards No. 123 (revised 2004) “Share Based Payment,” or SFAS No. 123R, required us to account for our stock-based awards as a compensation expense and, as a result, our net income and net income per share in subsequent periods has been significantly reduced.
 
 
None.
 
 
Our principal executive offices are located in Atlanta, Georgia adjacent to our network operations center, one of our P-NAPs and data center facilities. The Atlanta facility consists of 120,298 square feet under a lease agreement that expires in 2020. We lease other facilities to fulfill our real estate requirements in metropolitan areas and specific cities where our service points are located. We believe our existing facilities are adequate for our current needs and that suitable additional or alternative space will be available in the future on commercially reasonable terms as needed.
 
 
We currently, and from time to time, are involved in litigation incidental to the conduct of our business. Although the amount of liability that may result from these matters cannot be ascertained, we do not currently believe that, in the aggregate, such matters will result in liabilities material to our consolidated financial condition, results of operations or cash flows.
 
 
None.

 
PART II
 
 
Our common stock is listed on the NASDAQ Global Market under the symbol “INAP” and has traded on the NASDAQ Global Market since September 19, 2006. Our common stock traded on the American Stock Exchange under the symbol “IIP” from February 18, 2004 through September 18, 2006. Our common stock traded on the NASDAQ Small Cap Market from October 4, 2002 through February 17, 2004.   The following table presents, for the periods indicated, the range of high and low per share sales prices for our common stock, as reported on the NASDAQ Global Market since September 19, 2006 and on the American Stock Exchange prior to September 19, 2006.
 
On July 11, 2006, we implemented a one-for-ten reverse stock split of our common stock. The information in the following table has been adjusted to reflect this stock split. Our fiscal year ends on December 31.
 
27

 
Year Ended December 31, 2007:
 
High
   
Low
 
Fourth Quarter
  $ 17.18     $ 8.14  
Third Quarter
    16.15       13.04  
Second Quarter
    19.33       12.95  
First Quarter
    20.98       15.60  
                 
 
Year Ended December 31, 2006:
 
High
   
Low
 
Fourth Quarter
  $ 21.25     $ 14.10  
Third Quarter
    16.80       9.30  
Second Quarter
    15.50       9.00  
First Quarter
    10.60       4.20  
 
As of March 6, 2008, the number of stockholders of record of our common stock was approximately 24,600.

We have never declared or paid any cash dividends on our capital stock, and we do not anticipate paying cash dividends in the foreseeable future. We are prohibited from paying cash dividends under covenants contained in our current credit agreement. We currently intend to retain our earnings, if any, for future growth. Future dividends on our common stock, if any, will be at the discretion of our board of directors and will depend on, among other things, our operations, capital requirements and surplus, general financial condition, contractual restrictions, and such other factors as our board of directors may deem relevant.
 
The following table provides information regarding our current equity compensation plans as of December 31, 2007 (shares in thousands):


Equity Compensation Plan Information
 
 
Number of securities to
be issued upon exercise
of outstanding options,
warrants and rights
(a)
 
 
Weighted-average
exercise price of
outstanding options,
warrants and rights
(b)
 
Number of securities
remaining available for
future issuance under
equity compensation
plans (excluding
securities reflected in
column (a)
(c)
   
Equity compensation plans
approved by security holders
 
3,173
(1)
$ 13.29
 
5,990
  (2)
 
                 
Equity compensation plans not
approved by security holders
 
 
 
   
                 
Total
 
3,173
 
 $ 13.29
 
5,990
   
 

(1)
Excludes purchase rights accruing under the 2004 Employee Stock Purchase Plan ("Purchase Plan"). Under the Purchase Plan, each eligible employee may purchase up to $12,500 worth of common stock at each semi-annual purchase date (the last business day of June and December each year), but not more than $25,000 worth of such stock (determined on the basis of the fair market value per share on the date or dates such rights are granted) per calendar year his or her purchase right remains outstanding. The purchase price payable per share will be equal to ninety-five percent (95%) of the closing selling price per share of common stock on the semi-annual purchase date.

(2)
Includes 276,000 shares available for issuance under the Purchase Plan.
 

 
28

 
STOCK PERFORMANCE GRAPH
 
The graph set forth below compares cumulative total return to our stockholders from an investment in our common stock with the cumulative total return of the NASDAQ Market Index and the Hemscott Group Index, resulting from an initial assumed investment of $100 in each on December 31, 2002, assuming the reinvestment of any dividends, ending at December 31, of each year, 2003 - 2007, respectively.

GRAPHIC

 

 
29

 
 
The consolidated statement of operations data and other financial data presented below were prepared using our consolidated financial statements for the five years ended December 31, 2007. You should read this selected consolidated financial data together with the consolidated financial statements and related notes contained in this annual report on Form 10-K/A and in our 2006 and 2005 annual reports on Form 10-K/A and Form 10-K, respectively, filed with the SEC, as well as the section of this annual report and of our 2006 and 2005 annual reports on Form 10-K/A and Form 10-K, respectively, entitled, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

   
Year Ended December 31,
 
   
2007 (1)
   
2006 (2)
   
2005
   
2004
   
2003
 
   
(in thousands, except per share data)
 
                   
Revenue
  $ 234,090     $ 181,375     $ 153,717     $ 144,546     $ 138,580  
                                         
Operating costs and expenses:
                                       
Direct costs of network, sales and services,  exclusive of depreciation and amortization, shown below (3)
    118,394       97,338       81,958       76,990       78,200  
Direct costs of amortization of acquired technologies (3)
    4,165       516       577       579       134  
Direct costs of customer support
    16,547       11,566       10,670       10,180       9,483  
Product development
    6,564       4,475       4,864       6,412       6,982  
Sales and marketing
    31,533       27,173       25,864       23,411       21,491  
General and administrative
    32,512       22,104       20,096       24,772       16,711  
Depreciation and amortization
    22,242       15,856       14,737       15,461       37,087  
Gain on disposals of property and equipment
    (5 )     (113 )     (19 )     (3 )     (53
Restructuring and asset impairment
    11,349       323       44       3,644       1,084  
Acquired in-process research and development
    450                          
Amortization of deferred stock compensation
                60             390  
Pre-acquisition liability adjustment
    50                         (1,313
Total operating costs and expense
    243,801       179,238       158,851       161,446       170,196  
(Loss) income from operations
    (9,711     2,137       (5,134 )     (16,900 )     (31,616 )
Non-operating (income) expense
    (937 )     (1,551 )     (87     772       2,158  
(Loss) income before income taxes and equity in earnings of equity method investment
    (8,774     3,688       (5,047 )     (17,672 )     (33,774 )
(Benefit) provision for income taxes
    (3,080     145                    
Equity in (earnings) loss of equity-method investment, net of taxes
    (139 )     (114 )     (83     390       827  
Less deemed dividend related to beneficial conversion feature (4)  
                            34,576  
Net (loss) income
  $ (5,555 )   $ 3,657     $ (4,964 )   $ (18,062 )   $ (69,177 )
                                         
Net (loss) income per share:
                                       
Basic
  $ (0.12 )   $ 0.11     $ (0.15 )   $ (0.63 )   $ (3.96 )
Diluted
  $ (0.12 )   $ 0.10     $ (0.15 )   $ (0.63 )   $ (3.96 )
                                         
Weighted average shares used in per share calculations
                                       
Basic
    46,942       34,748       33,939       28,732       17,460  
Diluted
    46,942       35,739       33,939       28,732       17,460  
 
30

 
 
     December 31,  
    2007 (1)     2006     2005     2004     2003  
Consolidated Balance Sheet Data:
                             
Cash, cash equivalents and short-term
marketable securities
  $ 71,599     $ 58,882     $ 40,494     $ 45,985     $ 18,885  
Non-current marketable securities
                      4,656        
Total assets
    427,010       173,702       155,369       168,149       135,839  
Note payable and capital lease obligations, less current portion
    17,806       3,364       7,903       12,837       12,742  
Total stockholders’ equity
    346,633       126,525       109,728       113,738       70,524  
 
 
Year Ended December 31,
 
                                                                                                               
2007 (1)
 
2006
 
2005
 
2004
 
2003
 
Other Financial Data:
               
Purchases of property and equipment
  $ 30,271     $ 13,382     $ 10,161     $ 13,066     $ 3,799  
Net cash provided by (used in) operating activities
    27,592       29,599       5,493       (1,150 )     (11,175 )
Net cash (used in) provided by investing activities
    (36,393 )     (10,399 )     (9,428 )     (29,659 )     561  
Net cash provided by (used in) financing activities
    15,240       1,957       (5,454     45,747       4,280  
 
 
(1)
On February 20, 2007 we completed our acquisition of VitalStream, whereby VitalStream became a wholly-owned subsidiary of Internap. Prior to our acquisition of VitalStream, we did not offer proprietary CDN services, but instead, we were a reseller of third party CDN services. Under the purchase method of accounting, we allocated the total estimated purchase price to VitalStream’s net tangible and intangible assets based on their estimated fair values as of February 20, 2007. We recorded the excess purchase price over the value of the net tangible and identifiable intangible assets as goodwill. Also, as a result of the acquisition we issued approximately 12.2 million shares of Internap common stock.
 
 
(2)
Effective January 1, 2006, we adopted SFAS No. 123 (revised 2004), “Share-Based Payment” (SFAS No. 123R) and related interpretations, using the modified prospective transition method and therefore have not restated prior periods’ results. Prior to the adoption of SFAS No. 123R on January 1, 2006, we accounted for stock-based compensation plans under the recognition and measurement provisions of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. We also provided disclosures in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosures — an Amendment of FASB Statement No. 123.” Accordingly, no expense was recognized for options to purchase our common stock that we granted with an exercise price equal to fair market value at the date of grant and no expense was recognized in connection with purchases under employee stock purchase plans for any periods prior to January 1, 2006.

 
(3)
Prior to 2007, direct costs of amortization of acquired technologies were included in the caption direct costs of network, sales and services, exclusive of depreciation and amortization.  In 2007, we reclassified these costs to a separate caption.  These reclassifications had no effect on previously reported operating loss (income) or net loss (income).

 
(4)
In August 2003, we completed a private placement of our common stock, which resulted in a decrease of the conversion price of our series A preferred stock to $9.50 per share and an increase in the number of shares of common stock issuable upon conversion of all shares of series A preferred stock by 3.5 million shares. We recorded a deemed dividend of $34.6 million in connection with the conversion price adjustment, which is attributable to the additional incremental number of shares of common stock was issuable upon conversion of our series A preferred stock.
 
31

 
 
The following discussion should be read in conjunction with the consolidated financial statements and accompanying notes provided under Part II, Item 8 of this annual report on Form 10-K/A.

Overview

We deliver high performance and reliable Internet solutions through a suite of network optimization and delivery products and services. These solutions, combined with progressive and proactive technical support, enable companies to confidently migrate business-critical applications, including audio and video streaming and monetization services, to the Internet. Our suite of products and services support a broad range of Internet applications. We currently have approximately 3,800 customers, serving financial services, healthcare, technology, retail, travel, and media/entertainment markets. Our customers are located in the United States and abroad and include several Fortune 1000 and mid-tier enterprises. Our product and service offerings are complemented by Internet protocol, or IP, access solutions such as data center services, content delivery networks, or CDN, and managed security. We deliver services through our 50 service points across North America, Europe and the Asia-Pacific region. Our Private Network Access Points, or P-NAPs, feature multiple direct high-speed connections to major Internet networks including AT&T Inc., Sprint Nextel Corporation, Verizon Communications Inc., Savvis, Inc., Global Crossing Limited, and Level 3 Communications, Inc.
 
The key characteristic that differentiates us from our competition is our portfolio of patented and patent-pending route optimization solutions that address the inherent weaknesses of the Internet and overcome the inefficiencies of traditional IP connectivity options. Our intelligent routing technology can facilitate traffic over multiple carriers, as opposed to just one carrier's network, to ensure highly reliable performance over the Internet.
 
We believe our unique managed multi-network approach provides better performance, control and reliability compared to conventional Internet connectivity alternatives. Our service level agreements guarantee performance across the entire Internet in the United States, excluding local connections, whereas providers of conventional Internet connectivity typically only guarantee performance on their own network.

On October 12, 2006, we entered into a definitive agreement to acquire VitalStream Holdings, Inc., or VitalStream, in an all-stock transaction accounted for using the purchase method of accounting for business combinations. The transaction closed on February 20, 2007. Our results of operations include the activities of VitalStream from February 21, 2007 through December 31, 2007.
 
As discussed in note 18 to our consolidated financial statements, we revised our quarterly statement of operations for the quarter ended September 30, 2007 to appropriately record (1) $0.5 million for sales adjustments, which reduced net accounts receivable and revenue, and (2) $0.1 million for accretion of interest income that we initially included as unrealized gain in accumulated other comprehensive income within stockholders’ equity.  The effect of these revisions had no impact on our consolidated statement of cash flows.  We have determined that these adjustments are not material to our consolidated financial statements for any of the affected quarterly periods.  Accordingly, we have not revised the 2007 quarterly financial statements included in our previously filed Forms 10-Q for the quarterly periods ended March 31, June 30 and September 30, 2007, for these adjustments.
 
We operate in three business segments: IP services, data center services and CDN services. For additional information about these segments, see note 5 to the consolidated financial statements included in Part II, Item 8.
 
The following is a brief description of each of our reportable business segments.

IP Services
 
Our patented and patent-pending network performance optimization technologies address the inherent weaknesses of the Internet, allowing enterprises to take advantage of the convenience, flexibility and reach of the Internet to connect to customers, suppliers and partners. Our solutions take into account the unique performance requirements of each business application to ensure performance as designed, without unnecessary cost. Prior to recommending appropriate network solutions for our customers’ applications, we consider key performance objectives including (1) performance and cost optimization, (2) application control and speed and (3) delivery and reach. Our charges for IP services are based on a fixed-fee, usage or a combination of both fixed fee and usage.
 
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Our IP services segment also includes our flow control platform, or FCP. The FCP provides network performance management and monitoring for companies with multi-homed networks and redundant Internet connections.  The FCP proactively reviews customer networks for the best performing route or the most cost-effective and routes according to our customers’ requirements.  We offer FCP as either a one-time hardware purchase or as a monthly subscription service. Sales of FCP also generate annual maintenance fees and professional service fees for installation and ongoing network configuration. Since the FCP emulates our P-NAP service in many ways, this product affords us the opportunity to serve customers outside of our P-NAP market footprint. This product represents approximately 4% of our IP services revenue and approximately 2% of our consolidated revenue for the year ended December 31, 2007.

Data Center Services
 
Our data center services provide a single source for network infrastructure, IP and security, all of which are designed to maximize solution performance while providing a more stable, dependable infrastructure, and are backed by guaranteed service levels and our team of dedicated support professionals. We offer a comprehensive solution at 42 service points, including eight locations managed by us and 34 locations managed by third parties.

Data center services also enable us to have a more flexible product offering, including bundling our high performance IP connectivity and managed services, such as content delivery, along with hosting customers' applications. We charge monthly fees for data center services based on the amount of square footage that the customer leases in our facilities. We also have relationships with various providers to extend our P-NAP model into markets with high demand.

CDN Services
 
Our CDN services enable our customers to quickly and securely stream and distribute video, audio, advertising, and software to audiences across the globe through strategically located data centers. Providing capacity-on-demand to handle large events and unanticipated traffic spikes, content is delivered with high quality regardless of audience size or geographic location. Our MediaConsole® content management tool provides our customers the benefit of a single, easy to navigate system featuring Media Asset Management, Digital Rights Management, or DRM, support, and detailed reporting tools. With MediaConsole, our customers can use one application to manage and control access to their digital assets, deliver advertising campaigns, view network conditions, and gain insight into habits of their viewing audience.

Our CDN and monetization services provide a complete turnkey solution for the monetization of online media. These multi-faceted “live” and “on-demand” advertisement insertion and advertising placement solutions include a full campaign management suite, inventory prediction tools, audience research and metrics, and extensive reporting features to effectively track advertising campaigns in real-time. Online advertising solutions enable our customers to offset the costs associated with the creation, transformation, licensing, and management of online content. Prior to our acquisition of VitalStream on February 20, 2007, we did not offer proprietary CDN services, but instead, we were a reseller of third party CDN services for which results of operations are included in Other revenues and direct costs of network, sales and services, discussed below.

Other
 
Other revenues and direct costs of network, sales and services include our non-segmented results of operations, including certain reseller and miscellaneous services such as third party CDN services, termination fee revenue, other hardware sales, and consulting services.

Highlights and Outlook

 
·
Due to the nature of the services we provide, we generally price our IP services at a premium compared to the services offered by conventional Internet connectivity service providers. We believe customers with business-critical Internet applications will continue to demand the highest quality of service as their Internet connectivity needs grow and become even more complex and, as such, will continue to pay a premium for our high performance managed IP services.
     
 
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·
Our success in executing our premium pricing strategy depends, to a significant degree, on our ability to differentiate our connectivity solutions from lower cost alternatives. The key measures of our success in achieving this differentiation are revenue and customer growth. During 2007, we added approximately 1,500 net customers (including approximately 900 VitalStream customers that we added as part of the VitalStream acquisition), bringing our total to approximately 3,800 enterprise customers as of December 31, 2007. Revenue for the year ended December 31, 2007 increased 29% to $234.1 million, compared to revenue of $181.4 million for the year ended December 31, 2006.
     
 
·
We intend to increase revenue by leveraging the capabilities of our existing network access points. In our existing markets, we realize incremental margins as new customers are added. Additional volume in an existing market allows improved utilization of existing facilities and an improved ability to cost-effectively predict and acquire additional network capacity. We experienced a net increase in customers from 2006 to 2007. Conversely, decreases in the number of customers in an established market lead to decreased facility utilization and increase the possibility that direct network resources are not cost-efficiently employed. These factors have a direct bearing on our financial position and results of operations.
     
 
·
We offer a 100% operational uptime guarantee for our network performance management. Coupled with the lowest packet loss and latency in the industry, we provide our customers with a proactive industry-leading Service Level Agreement (SLA) that covers the entire Internet - not just one single network. Unlike our competitors, we believe so strongly in the consistent performance of our network that we offer proactive SLA notification and automatic bill credits if we ever break our SLAs.  We believe that this commitment allows us to provide the best network performance available.

Developments in 2007

VitalStream Acquisition.> On February 20, 2007, we completed the previously announced acquisition of VitalStream Holdings, Inc., or VitalStream, for approximately $214.0 million, whereby VitalStream became a wholly-owned subsidiary of Internap. VitalStream provides products and services for storing and delivering digital media to large audiences over the Internet and advertisement insertion and related advertising services to companies that stream digital media over the Internet. VitalStream enhances our position as a leading provider of high performance route control products and services by adding complementary service offerings in the rapidly growing content delivery and on-line advertising markets. Integrating VitalStream's digital media delivery platform into our portfolio of products and services enables us to provide customers with one of the most complete product lines in content delivery solutions, content monetization and on-line advertising, while supporting the significant long-term growth opportunities in the network services market. We also considered the following:

 
·
VitalStream’s services were a logical extension and complement to our high performance route control products and services.
 
·
We evaluated demand for CDN services within our customer base and determined that a market for proprietary CDN services existed.
 
·
VitalStream’s services offered our legacy customers additional high growth and high margin revenue streams.
 
·
We believed that large audio and video files are more effectively delivered over the Internet with a combination of VitalStream’s platform and our route management network.
 
·
VitalStream’s initiatives in the rich media advertising services business present an entirely new set of opportunities and potential customer relationships for us, as advertisers seek to access a large and growing base of Internet users that watch increasing amounts of video online.
 
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We accounted for the acquisition using the purchase method of accounting in accordance with SFAS No. 141, “Business Combinations.” Our results of operations include the activities of VitalStream from February 21, 2007 through December 31, 2007.
 
Restructuring Liability>.   On March 31, 2007, we incurred a restructuring and impairment charge totaling $10.3 million. The charge was the result of a review of our business, particularly in light of our acquisition of VitalStream, and our plan to finalize the overall integration and implementation plan before the end of the first quarter. The charge to expense included $7.8 million for leased facilities, representing both the net present value of costs less anticipated sublease recoveries that will continue to be incurred without economic benefit to us and costs to terminate leases before the end of their term. The charge also included severance payments of $1.1 million for the termination of certain Internap employees and $1.4 million for impairment of assets. Related expenditures are estimated to be $10.7 million, of which $3.7 million has been paid during the year ended December 31, 2007, and the balance continuing through December 2016, the last date of the longest lease term. The impairment charge of $1.3 million was related to the leases referenced above and less than $0.1 million for other assets.
 
We also incurred a $1.1 million impairment recorded for a sales order-through-billing system, which was a result of an evaluation of the existing infrastructure relative to our new financial accounting system and the acquisition of VitalStream.
 
Write-Off of Investment>.  In connection with the preparation of our quarterly report for the quarter ended June 30, 2007, we wrote-off an investment, totaling $1.2 million, representing the remaining carrying value of our investment in series D preferred stock of Aventail Corporation, or Aventail. We made an initial cash investment of $6.0 million in Aventail series D preferred stock pursuant to an investment agreement in February 2000. In connection with a subsequent round of financing by Aventail, we recognized an initial impairment loss on our investment of $4.8 million in 2001. On June 12, 2007, SonicWall, Inc. announced that it had entered into an agreement to acquire Aventail for approximately $25.0 million in cash. The transaction closed on July 11, 2007, all shares of series D preferred stock were cancelled and the holders of series D preferred stock did not receive any consideration for such shares.  Consequently, we recorded a write-off of our investment in Aventail to reduce our carrying value to $0.
 
Rights Agreement. >On March 15, 2007, the Board of Directors declared a dividend of one preferred share purchase right, or a Right, for each outstanding share of common stock, par value $0.001 per share, of the Company. The dividend was payable on March 23, 2007 to the stockholders of record on that date. Each Right entitles the registered holder to purchase from the Company one one-thousandth of a share of Series B Preferred Stock of the Company, par value $0.001 per share, or the Preferred Shares, at a price of $100.00 per one one-thousandth of a Preferred Share, subject to adjustment. The description and terms of the Rights are set forth in a Rights Agreement between the Company and American Stock Transfer & Trust Company, as Rights Agent dated April 11, 2007.
 
Data Center Expansion. >  On June 12, 2007, we announced that we approved an investment of up to $40.0 million to fund the expansion of our data center facilities in several key markets. We anticipate implementing the expansion over the next several calendar quarters, with at least a portion of the funding to be provided under our credit agreement, discussed below. Through December 31, 2007, we have spent less than $10.0 million.
 
Credit Agreement. >On September 14, 2007, we entered into a $35.0 million credit agreement. We discuss this agreement in note 10 to the consolidated financial statements and the section captioned “Liquidity and Capital Resources” under “Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations.”  At December 31, 2007, the outstanding balance was $19.8 million, of which we used $4.4 million to repay prior debt, approximately $7.8 million for capital expenditures and the balance for general corporate and other purposes.  The availability under the revolving credit facility and term loan was $1.1 million and $10.0 million, respectively at December 31, 2007.

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Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, and expense, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those summarized below. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ materially from these estimates under different assumptions or conditions.

Management believes the following critical accounting policies affect the judgments and estimates used in the preparation of our consolidated financial statements.

Revenue recognition>. The majority of our revenue is derived from high performance IP services, related data center services, CDN services, and other ancillary products and services throughout the United States. Our IP services revenue is derived from the sale of high performance Internet connectivity services at fixed rates or usage-based pricing to our customers that desire a DS-3 or faster connection.  Slower T-1 and fractional DS-3 connections are provided at fixed rates.  Data center revenue includes both physical space for hosting customers’ network and other equipment plus associated services such as redundant power and network connectivity, environmental controls and security.  Data center revenue is based on occupied square feet and both allocated and variable-based usage.  CDN revenue includes three components, none of which are sold separately: (1) data storage; (2) streaming/delivery and (3) a user interface/reporting tool.  We provide the CDN service components via internally developed and acquired technology that resides on our network.  CDN revenue is based on either fixed rates or usage-based pricing.  All of the foregoing revenue arrangements have contractual terms and in many instances, include minimum usage commitments.  Other ancillary products and services include our Flow Control Platform, or FCP, product, server management and installation, virtual private networking, managed security, data backup, remote storage and restoration.
 
We recognize revenue in accordance with the Securities and Exchange Commission’s Staff Accounting Bulletin No. 104, Revenue Recognition, or SAB No. 104, and the Financial Accounting Standards Board’s, or FASB, Emerging Issues Task Force Issue No. 00-21, Revenue Arrangements with Multiple Deliverables, or EITF No. 00-21.  Revenue is recognized when persuasive evidence of an arrangement exists, the product or service has been delivered, the fees are fixed or determinable and collectibility is probable. For most of our IP, data center and CDN revenue, services are delivered ratably over the contract term. Contracts and sales or purchase orders are used to determine the existence of an arrangement. We test for availability or connectivity to verify delivery of our services. We assess whether the fee is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment.  Because the software component of our FCP is more than incidental to the product as a whole, we recognize associated FCP revenue in accordance with the American Institute of Certified Public Accountants’ (AICPA) Statement of Position 97-2, Software Revenue Recognition.
 
We derive revenue from the sale of IP services, data center services and CDN services to customers under contracts that generally commit the customer to a minimum monthly level of usage on a calendar month basis and provide the rate at which the customer must pay for actual usage above the monthly minimum. For these services, we recognize the monthly minimum as revenue each month provided that an enforceable contract has been signed by both parties, the service has been delivered to the customer, the fee for the service is fixed or determinable and collection is reasonably assured. Should a customer’s usage of our services exceed the monthly minimum, we recognize revenue for such excess in the period of the usage. We record the installation fees as deferred revenue and recognize as revenue ratably over the estimated life of the customer arrangement. We also derive revenue from services sold as discrete, non-recurring events or based solely on usage. For these services, we recognize revenue after both parties have signed an enforceable contract, the fee is fixed or determinable, the event or usage has occurred and collection is reasonably assured.

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We also enter into multiple-element arrangements or bundled services, such as combining IP services with data center, CDN services or both.  When we enter into such arrangements, we account for each element separately over its respective service period or at the time of delivery, provided that there is objective evidence of fair value for the separate elements. Objective evidence of fair value includes the price charged for the element when sold separately. If we cannot objectively determine the fair value of each element, we recognize the total value of the arrangement ratably over the entire service period to the extent that we have begun to provide the services, and other revenue recognition criteria have been satisfied.
 
Deferred revenue consists of revenue for services to be delivered in the future and consist primarily of advance billings, which are amortized over the respective service period. Revenue associated with billings for installation of customer network equipment are deferred and amortized over the estimated life of the customer relationship, which was two to three years for each of the three years in the period ended December 31, 2007.  Revenue for installation services is deferred and amortized because the installation service is integral to our primary service offering and does not have value to a customer on a stand-alone basis. Deferred post-contract customer support associated with sales of our FCP solution and similar products are amortized ratably over the contract period, which is generally one year.
 
Customer credit risk>. We routinely review the creditworthiness of our customers. If we determine that collection of service revenue is uncertain, we do not recognize revenue until collection  is probable. Additionally, we maintain allowances for doubtful accounts resulting from the inability of our customers to make required payments on accounts receivable. The allowance for doubtful accounts is based upon specific and general customer information, which also includes estimates based on management's best understanding of the customer’s ability to pay. A customer’s ability to pay takes into consideration payment history, legal status (i.e., bankruptcy) and the status of services we are providing.  Once we have exhausted all collection efforts, we write the uncollectible balance off against the allowance for doubtful accounts.
 
We record an amount for sales adjustments, which reduces net accounts receivable and revenue. The amount for sales adjustments is based upon specific and general customer information, including outstanding promotional credits, customer disputes, credit adjustments not yet processed through the billing system, and historical activity.
 
Accounting for leases and leasehold improvements>. We record leases as capital or operating leases and account for leasehold improvements in accordance with SFAS No. 13, “Accounting for Leases” and related literature. We record rent expense for operating leases in accordance with FASB Technical Bulletin (FTB) No. 88-1, “Issues Relating to Accounting for Leases.” This FTB requires lease agreements that include periods of free rent or other incentives, specific escalating lease payments, or both, to be recorded on a straight-line or other systematic basis over the initial lease term and those renewal periods that are reasonably assured. The difference between rent expense and rent paid is recorded as deferred rent in non-current liabilities in the consolidated balance sheets.

Investments>. We account for investments without readily determinable fair values at historical cost, as determined by our initial investment. The recorded value of cost-basis investments is periodically reviewed to determine the propriety of the recorded basis. When a decline in the value that is judged to be other than temporary has occurred, based on available data, the cost basis is reduced and an investment loss is recorded. We incurred a charge during the three months ended June 30, 2007, totaling $1.2 million, representing the write-off of the remaining carrying value of our investment in series D preferred stock of Aventail Corporation, or Aventail. See note 6 to the consolidated financial statements for further discussion of this investment and the recorded loss.

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We account for investments that provide us with the ability to exercise significant influence, but not control, over an investee using the equity method of accounting. Significant influence, but not control, is generally deemed to exist if we have an ownership interest in the voting stock of the investee of between 20% and 50%, although other factors, such as minority interest protections, are considered in determining whether the equity method of accounting is appropriate. As of December 31, 2007, Internap Japan Co, Ltd. (Internap Japan), our joint venture with NTT-ME Corporation of Japan and NTT Holdings, qualifies for equity method accounting. We record our proportional share of the income and losses of Internap Japan one month in arrears on the consolidated balance sheets as a component of non-current investments and as a separate caption on the consolidated statement of operations.

Pursuant to our formal investment policy, investments in marketable securities include high credit quality corporate debt securities, auction rate securities, commercial paper, and U.S. Government Agency debt securities. Auction rate securities are variable rate bonds tied to short-term interest rates with maturities on the face of the securities in excess of 90 days and have interest rate resets through a modified Dutch auction, at predetermined short-term intervals, usually every 7, 28 or 35 days.  Auction rate securities generally trade at par and are callable at par on any interest payment date at the option of the issuer.  Interest received during a given period is based upon the interest rate determined through the auction process.  Although these securities are issued and rated as long term bonds, they are priced and traded as short-term instruments because of the liquidity provided through the interest rate reset. All of our marketable securities are classified as available for sale and are recorded at fair value with changes in fair value reflected in other comprehensive income.

Goodwill.> We account for goodwill under SFAS No. 142, “Goodwill and Other Intangible Assets.” This statement requires an impairment-only approach to accounting for goodwill. The SFAS No. 142 goodwill impairment model is a two-step process. As a first step, it requires a comparison of the book value of net assets to the fair value of the related operations that have goodwill assigned to them. If the fair value is determined to be less than book value, a second step is performed to compute the amount of the impairment. In this process, a fair value for goodwill is estimated, based in part on the fair value of the operations used in the first step, and is compared to the carrying value for goodwill. Any shortfall of the fair value below carrying value represents the amount of goodwill impairment. SFAS No. 142 requires goodwill to be tested for impairment annually at the same time every year and when an event occurs or circumstances change such that it is reasonably possible that impairment may exist. We selected August 1 as our annual testing date. We also assess on a quarterly basis whether any events have occurred or circumstances have changed that would indicate an impairment could exist.
 
Accruals for disputed telecommunication costs>. In delivering our services, we rely on a number of Internet network, telecommunication and other vendors. We work directly with these vendors to provision services such as establishing, modifying or discontinuing services for our customers. Because of the volume of activity, billing disputes inevitably arise. These disputes typically stem from disagreements concerning the starting and ending dates of service, quoted rates, usage, and various other factors. For potential billing errors made in the vendor’s favor, for example a duplicate billing, we initiate a formal dispute with the vendor and record the related cost and liability on a range of 5% to 100% of the disputed amount, depending on our assessment of the likely outcome of the dispute. Conversely, for billing errors in our favor, such as the vendor’s failure to invoice us for new service, we record an estimate for the related cost and liability based on the full amount that we should have been invoiced. Disputed costs, both in the vendors’ favor and our favor, are researched and discussed with vendors on an ongoing basis until ultimately resolved. Estimates are periodically reviewed by management and modified in light of new information or developments, if any. Conversely, any resolved disputes that will result in a credit over the disputed amounts are recognized in the appropriate month when the resolution has been determined. Because estimates regarding disputed costs include assessments of uncertain outcomes, such estimates are inherently vulnerable to changes due to unforeseen circumstances that could materially and adversely affect our consolidated financial condition, results of operations and cash flows.

Accrued liabilities>. Similar to accruals for disputed telecommunications costs above, it is necessary for us to estimate other significant costs such as utilities and sales, use, telecommunications, and other taxes. These estimates are often necessary either because invoices for services are not received on a timely basis from our vendors or by virtue of the complexity surrounding the costs. In every instance in which an estimate is necessary, we record the related cost and liability based on all available facts and circumstances, including but not limited to historical trends, related usage, forecasts, and quotes. Management periodically reviews and modifies estimates in light of new information or developments, if any. Because estimates regarding accrued liabilities include assessments of uncertain outcomes, such estimates are inherently vulnerable to changes due to unforeseen circumstances that could materially and adversely affect our results of operations and cash flows.

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Restructuring liability>. When circumstances warrant, we may elect to exit certain business activities or change the manner in which we conduct ongoing operations. When we make such a change, management will estimate the costs to exit a business or restructure ongoing operations. The components of the estimates may include estimates and assumptions regarding the timing and costs of future events and activities that represent management's best expectations based on known facts and circumstances at the time of estimation. Management periodically reviews its restructuring estimates and assumptions relative to new information, if any, of which it becomes aware. Should circumstances warrant, management will adjust its previous estimates to reflect what it then believes to be a more accurate representation of expected future costs. Because management's estimates and assumptions regarding restructuring costs include probabilities of future events, such estimates are inherently vulnerable to changes due to unforeseen circumstances, changes in market conditions, regulatory changes, changes in existing business practices, and other circumstances that could materially and adversely affect our results of operations. A 10% change in our restructuring estimates in a future period, compared to the $10.1 million restructuring liability at December 31, 2007 would result in an $1.0 million expense or benefit in the statement of operations during the period in which the change in estimate occurred.

Deferred taxes>. We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized.  Historically, we have recorded a valuation allowance equal to our net deferred tax assets. Although we consider the potential for future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event we determine we would be able to realize our deferred tax assets in the future in excess of our net recorded amount, an adjustment to reduce the valuation allowance would increase income in the period such determination was made.

For the year ended December 31, 2007, the tax provision includes a net benefit of $3.5 million related to the release of the valuation allowance associated with U.K. deferred tax assets. The gross amount of U.K. deferred tax assets was $4.4 million, which was offset by a reserve of $0.9 million. The net tax provision benefit of $3.5 million reduced our loss for the year ended December 31, 2007.

The reduction in valuation allowance was due to the existence of sufficient positive evidence as of December 31, 2007 to indicate that our net operating losses in the U.K. would more likely than not be realized in the future. The evidence primarily consists of the results of prior performance in the U.K. and the expectation of future performance based on historical results.  We will continue to assess in the future the recoverability of U.S. and other deferred tax assets, and whether or not the valuation allowance should be reduced relative to the U.S. and other deferred tax assets outside the U.K.

Stock-based compensation.> We account for stock-based instruments issued to employees in exchange for their services under the fair value recognition provisions of SFAS No. 123 (revised 2004), “Share-Based Payment,” or SFAS No. 123R, and related interpretations. Under SFAS No. 123R, share-based compensation cost is measured at the grant date based on the calculated fair value of the award. The expense is recognized over the employee’s requisite service period, generally the vesting period of the award. Prior to the adoption of SFAS No. 123R on January 1, 2006, we utilized the disclosure only provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” and accounted for stock-based compensation plans under the recognition and measurement provisions of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, we did not recognize any expense for options to purchase our common stock granted with an exercise price equal to fair market value at the date of grant and did not recognize any expense in connection with purchases under our employee stock purchase plans for any periods prior to January 1, 2006.

We elected to adopt SFAS No. 123R using the modified prospective application method. Under this method, compensation cost recognized during the period includes: (1) compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123 amortized over the awards’ vesting period, and (2) compensation cost for all share-based payments granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123R amortized on a straight-line basis over the awards’ vesting period. The fair value of stock options is estimated at the date of grant using the Black-Scholes option pricing model with weighted average assumptions for the activity under our stock plans. Option pricing model input assumptions such as expected term, expected volatility, and risk-free interest rate, impact the fair value estimate. Further, the forfeiture rate impacts the amount of aggregate compensation. These assumptions are subjective and generally require significant analysis and judgment to develop.
 
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The expected term represents the weighted average period of time that granted options are expected to be outstanding, giving consideration to the vesting schedules and our historical exercise patterns. Because our options are not publicly traded, assumed volatility is based on the historical volatility of our stock. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant for periods corresponding to the expected life of the options. We have also used historical data to estimate option exercises, employee termination and stock option forfeiture rates. Changes in any of these assumptions could materially impact our results of operations in the period the change is made.

Recent Accounting Pronouncements

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,or SFAS No. 157. SFAS No. 157 defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles, or GAAP, and expands disclosures about fair value measurements. SFAS No. 157 is effective for fiscal years beginning after December 15, 2007. In February 2008, the FASB issued Staff Position, or FSP, FAS 157-1, which provides supplemental guidance on the application of SFAS No. 157, and FSP FAS 157-2, which delays the effective date of SFAS No. 157 for nonfinancial assets and nonfinancial liabilities. We are currently in the process of evaluating the impact that the adoption of SFAS No. 157 will have on our financial position, results of operations and cash flows.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,or SFAS NO. 159. SFAS No. 159 permits companies to choose to measure, on an instrument-by-instrument basis, many financial instruments and certain other assets and liabilities at fair value that are not currently required to be measured at fair value. SFAS No. 159 is effective as of the beginning of a fiscal year that begins after November 15, 2007. While we will not elect to adopt fair value accounting to any assets or liabilities allowed by SFAS No. 159, we are currently in the process of evaluating SFAS No. 159 and its potential impact to us.

In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations,or SFAS No. 141R. SFAS No. 141R replaces SFAS No. 141, “Business Combinations.” SFAS No. 141R establishes principles and requirements for how an acquiror recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any noncontrolling interest in the acquiree, and the goodwill acquired or a gain from a bargain purchase. SFAS No. 141R also determines disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. SFAS No. 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of a fiscal year that begins on or after December 15, 2008 and has implications for acquisitions that occur prior to this date. We are currently in the process of evaluating the impact that the adoption of SFAS No. 141R will have on our financial position, results of operations and cash flows.

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements,” or SFAS No. 160. SFAS No. 160 amends Accounting Research Bulletin 51, Consolidated Financial Statements, or ARB 51, and requires all entities to report noncontrolling (minority) interests in subsidiaries within equity in the consolidated financial statements, but separate from the parent shareholders’ equity. SFAS No. 160 also requires any acquisitions or dispositions of noncontrolling interests that do not result in a change of control to be accounted for as equity transactions. Further, SFAS No. 160 requires that a parent recognize a gain or loss in net income when a subsidiary is deconsolidated. SFAS No. 160 is effective for fiscal years beginning on or after December 15, 2008. We do not expect the adoption of SFAS No. 160 will have a significant, if any, impact on our financial position, results of operations and cash flows.
 
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Revenues.> Revenues are generated primarily from the sale of IP services, data center services and CDN services. Our revenues typically consist of monthly recurring revenues from contracts with terms of one year or more. These contracts usually have fixed minimum commitments based on a certain level of usage with additional charges for any usage over a specified limit. We also provide premise-based route optimization products and other ancillary services, such as server management and installation services, virtual private networking services, managed security services, data back-up, remote storage, restoration services, and professional services.

Direct costs of network, sales and services. >Direct costs of network, sales and services are comprised primarily of:

          ·
  
costs for connecting to and accessing Internet network service providers, or ISPs, and competitive local exchange providers;
     
  ·
 
facility and occupancy costs for housing and operating our and our customers’ network equipment;
     
·
 
costs of license fees for operating systems software, advertising royalties to content rights owners and advertising distribution costs;
     
·
 
costs incurred for providing additional third party services to our customers; and
     
          ·
 
costs of FCP solutions sold.
     
To the extent a network access point is located a distance from the respective ISP, we may incur additional local loop charges on a recurring basis. Connectivity costs vary depending on customer demands and pricing variables while network access point facility costs are generally fixed in nature. Direct costs of network, sales and services do not include compensation, depreciation or amortization.

Direct costs of amortization of acquired technologies.> Direct costs of amortization of acquired technologies are for technologies acquired through business combinations that are an integral part of the services and products we sell. The cost of the acquired technologies is amortized over original lives of three to eight years.

Direct costs of customer support>. Direct costs of customer support consist primarily of compensation and other personnel costs for employees engaged in connecting customers to our network, installing customer equipment into network access point facilities, and servicing customers through our network operations centers. In addition, facilities costs associated with the network operations center are included in direct costs of customer support.

Product development costs. >Product development costs consist principally of compensation and other personnel costs, consultant fees and prototype costs related to the design, development and testing of our proprietary technology, enhancement of our network management software and development of internal systems. Costs for software to be sold, leased or otherwise marketed are capitalized upon establishing technological feasibility and ending when the software is available for general release to customers. Costs associated with internal use software are capitalized when the software enters the application development stage until the software is ready for its intended use. All other product development costs are expensed as incurred.

Sales and marketing costs. >Sales and marketing costs consist of compensation, commissions and other costs for personnel engaged in marketing, sales and field service support functions, as well as advertising, tradeshows, direct response programs, new service point launch events, management of our web site, and other promotional costs.

General and administrative costs. >General and administrative costs consist primarily of compensation and other expense for executive, finance, human resources and administrative personnel, professional fees, and other general corporate costs.

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The following table sets forth, as a percentage of total revenue, selected statement of operations data for the periods indicated:
 
     
Year Ended December 31,
 
     
2007
 
2006
 
2005
 
Revenues:
               
Internet protocol (IP) services
   
51.2 
%
60.5
%
68.3
%
Data center services
   
35.5 
 
31.0
 
24.1
 
Content delivery network (CDN) services
   
7.6 
 
 
 
Other
   
5.7 
 
8.5
 
7.6
 
Total revenues
   
100.0
 
100.0
 
100.0
 
                 
Operating costs and expenses:
               
Direct costs of network, sales and services, exclusive of depreciation and amortization, shown below:
               
    IP services
   
18.7
 
21.9
 
25.0
 
    Data center services
   
25.4
 
25.6
 
22.9
 
    CDN services
   
2.8
 
 
 
    Other
   
3.7
 
6.1
 
5.4
 
Direct costs of amortization of acquired technologies
   
1.8
 
0.3
 
0.4
 
Direct costs of customer support
   
7.1
 
6.4
 
6.9
 
Product development
   
2.8
 
2.5
 
3.2
 
Sales and marketing
   
13.4
 
15.0
 
16.8
 
General and administrative
   
13.9
 
12.2
 
13.1
 
Depreciation and amortization
   
9.5
 
8.7
 
9.6
 
Restructuring and asset impairment
   
4.9
 
0.2
 
 
Other operating costs and expenses
   
0.2
 
(0.1
 )
 
Total operating costs and expenses
   
104.2
 
98.8
 
103.3
 
                 
(Loss) income from operations
   
( 4.2
) %
1.2
%
(3.3
) %
                 

Revenues> 
 
Revenues for the years ended December 31, 2007, 2006 and 2005 are summarized as follows (in thousands):
 
   
Year Ended December 31,
 
   
2007
   
2006
   
2005
 
Revenues:
                 
Internet protocol (IP) services
  $ 119,848     $ 109,748     $ 105,032  
Data center services
    83,058       56,152       36,996  
Content delivery network (CDN) services
    17,718              
Other
      13,466       15,475       11,689  
    $ 234,090     $ 181,375     $ 153,717  

Segment information.> We have three business segments: IP services, data center services and CDN services. IP services include managed and premise-based high performance IP and route optimization technologies. Data center services include hosting of customer applications directly on our network to eliminate issues associated with the quality of local connections. Data center services are increasingly bundled with our high performance IP connectivity services. CDN services include products and services for storing, delivering and monetizing digital media to large global audiences over the Internet. Prior to our acquisition of VitalStream on February 20, 2007, we did not offer proprietary CDN services, but instead, we were a reseller of third party CDN services for which revenues and direct costs are included in other revenues and direct costs of network, sales and services, discussed below.

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Our reportable segments are strategic business units that offer different products and services. As of December 31, 2007, our customer base totaled approximately 3,800 customers across more than 20 metropolitan markets.

IP services>. Revenue for IP services increased $10.1 million, or 9%, to $119.9 million for the year ended December 31, 2007, compared to $109.7 million for the year ended December 31, 2006. The increase in IP revenue is driven by an increase in demand, partially offset by a decline in pricing, and an increase in sales of our premise-based FCP products and other large hardware sales. We continue to experience increasing demand for our traditional IP services, with IP traffic for the year ended December 31, 2007 increasing approximately 35% from the year ended December 31, 2006. The increase in IP traffic has resulted from both existing and new customers requiring greater overall capacity due to growth in the usage of their applications, as well as in the nature of applications consuming greater amounts of bandwidth. In particular, we have continued to add high-traffic customers through competitive IP pricing and minimum commitments during the year ended December 31, 2007. New IP services customers added approximately $1.7 million of revenue. Ongoing industry-wide pricing declines over the last 12 months, however, offset a portion of our gains in customers and IP traffic. The blended rate in megabits per second, or Mbps, decreased approximately 23% annually from December 31, 2006 to December 31, 2007. We recorded approximately $0.5 million of sales adjustments in the fourth quarter of 2007 related predominantly to disputes over contractual service periods.
 
Revenue for IP services increased $4.7 million, or 5%, to $109.7 million for the year ended December 31, 2006, compared to $105.0 million for the year ended December 31, 2005. This change is due to the increase in demand for IP traffic, partially offset by declining prices. During the year ended December 31, 2006, IP traffic over our networks increased approximately 83% from the year ended December 31, 2005. The increase in IP traffic has come as both existing and new customers require greater overall capacity due to growth in the usage of their applications as well as in the nature of applications consuming greater amounts of bandwidth. In particular, we added a number of high-traffic customers through competitive IP pricing and minimum commitments during the year ended December 31, 2006.

Data center services.> Data center services are a significant source of revenue growth for our business. Revenue for data center services increased $26.9 million, or 48%, to $83.1 million for the year ended December 31, 2007, compared to $56.2 million for the year ended December 31, 2006. During the year ended December 31, 2007, we (1) implemented a broad-based rate increase, generating additional revenue of approximately $8.0 million, (2) began executing a data center growth initiative and (3) completed the build-out of our Seattle facility.  The overall increase in revenue has resulted from both new and existing customers, with new customers adding approximately $1.7 million of revenue during 2007. The remaining increase is largely due to existing customers using more space within our facilities, and the design and installation revenue from new customers. We have also structured our data center business to accommodate larger, global customers and ensure a platform for robust traffic growth.

Revenue for data center services increased $19.2 million, or 52%, to $56.2 million for the year ended December 31, 2006, compared to $37.0 million for the year ended December 31, 2005. The revenue increase is primarily attributable to growth in new and existing data center customers. Revenue growth is facilitated in part by the continued expansion of our available data center space and our continued efforts to bundle our IP and data center services. The demand for data center services has outpaced industry-wide supply, which has allowed us to increase the overall pricing for the data center component of our pricing models.

CDN services>. Revenue for our CDN services segment was $17.7 million for the year ended December 31, 2007. This activity represents the operations from our acquisition of VitalStream, which  we completed on February 20, 2007. Revenue for the year was slightly lower than originally anticipated as we completed the integration of the VitalStream business with and into our network and infrastructure.  As previously noted, we did not offer proprietary CDN services prior to our acquisition of VitalStream, but instead, we were a reseller of third party CDN services, which is included in Other revenue, below. We expect CDN to be an area of significant growth and have upgraded and expanded related infrastructure, including in Europe and Asia, to serve the expected industry-wide demand, particularly in those regions. In December 2007, we extended our 100% uptime SLA to CDN services. In the second half of 2007, the Company experienced platform instability in its CDN business, which caused an increase in customer dissatisfaction and a higher than historical amount of customer disputes over service billings. In the fourth quarter of 2007, we recorded a total of appoximately $1.4 million in sales and billing adjustments related to both service interruptions and disputes over contractual service periods. These sales and  billing adjustments have been recorded against revenue. We have substantially completed integrating our combined networks through technological improvements and systems integration with operational stability achieved late in the year and expect this integration to result in a decrease in performance-related adjustments in 2008.
 
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Other>. Other revenues primarily include reseller and miscellaneous services such as third party CDN services, termination fee revenue, referral fees for other hardware sales, and consulting services. Other revenues decreased substantially as the revenue streams from our acquisition of VitalStream replaced the activity of the former third party CDN service provider.
 
Direct Costs of Network, Sales and Services (exclusive of depreciation and amortization)
 
IP services>. Direct costs of IP network, sales and services, exclusive of depreciation and amortization, increased $3.9 million, or 10%, to $43.7 million for the year ended December 31, 2007, compared to $39.7 million for the year ended December 31, 2006. For the year ended December 31, 2006 compared to the year ended December 31, 2005, the related direct costs increased $1.4 million, or 4%, to $39.7 million as of December 31, 2006, compared to $38.4 million as of December 31, 2005.  While IP services revenue has increased, the direct costs of IP network, sales and services has continued to be approximately 36% of IP services revenue for each of the last three years, even as we have had a change in the mix of revenue with traditionally higher margin IP services, lower margin high volume customers, and FCP and other hardware sales.  Connectivity costs vary based upon customer traffic and other demand-based pricing variables. Costs for IP services are especially subject to ongoing negotiations for pricing and minimum commitments. As our IP traffic continues to grow, we expect to have greater bargaining power for lower bandwidth rates and more opportunities to proactively manage network costs, such as utilization and traffic optimization among network service providers.
 
Data center services.> The direct costs of data center services, exclusive of depreciation and amortization, increased $13.0 million, or 28%, to $59.4 million for the year ended December 31, 2007, compared to $46.5 million for the year ended December 31, 2006. For the year ended December 31, 2006 compared to the year ended December 31, 2005, the related direct costs increased $11.2 million, or 32%, to $46.5 million as of December 31, 2006, compared to $35.2 million as of December 31, 2005. As data center services revenue has increased, direct costs of data center services as a percentage of corresponding revenue have decreased to approximately 72%, 83% and 95% for the year ended December 31, 2007, 2006 and 2005, respectively. This trend is the result of an increase in total occupancy at higher rates, as discussed with revenues above, while substantial direct costs are subject to previously negotiated rates.  Direct costs of data center services, exclusive of depreciation and amortization, have substantial fixed cost components, primarily for rent, but also significant demand-based pricing variables, such as utilities, which are highest in the summer for cooling the facilities.
 
The growth in data center services largely follows our expansion of data center space. The demand for data center services is outpacing industry-wide supply, which contributes to our improvement of data center direct costs as a percentage of data center revenue. At December 31, 2007, we had approximately 179,000 square feet of data center space with a utilization rate of approximately 75%, as compared to approximately 149,000 square feet of data center space with a utilization rate of approximately 79% at December 31, 2006. At December 31, 2005, we had approximately 124,000 square feet of data center space with a utilization rate of approximately 76%. Our recent data center expansion has resulted in the lower utilization rate as of December 31, 2007 compared to December 31, 2006. However, the recent expansion should provide us lower costs per occupied square foot in future periods, enabling us to increase revenue compared to relatively lower direct costs of data center services.  At December 31, 2007, 104,000 square feet, or approximately 58% of total square feet, was in data centers operated by us versus data centers operated by our vendors, or partner sites. Additionally, approximately 62% of our available square feet as of December 31, 2007 are in data centers operated by us.
 
CDN services>. Direct costs of network, sales and services, exclusive of depreciation and amortization, for our CDN services segment were $6.6 million for the year ended December 31, 2007. Direct costs of CDN network, sales and services were approximately 37% of CDN services revenue for the year ended December 31, 2007, which was a little more favorable than our initial expectations. This activity represents the operations from our acquisition of VitalStream, which was completed on February 20, 2007. The direct costs include the benefit of lower rates throughout the year as we have migrated VitalStream’s former contracts and terms to our own. Direct costs of CDN network sales and services also includes an allocation of $0.7 million from direct costs of IP network sales and services based on the average cost of actual usage by the CDN segment.  As previously noted, we did not offer proprietary CDN services prior to our acquisition of VitalStream, but instead, we were a reseller of third party CDN services, which is included in Other direct costs, below. We expect CDN to be an area of significant growth and are expanding related infrastructure, including in Europe and Asia, to serve the expected industry-wide demand, particularly in those regions.

44

 
Other>. Other direct costs of network, sales and services, exclusive of depreciation and amortization primarily include reseller and miscellaneous services such as third party CDN services and consulting services. These costs decreased substantially as the revenue streams from our acquisition of VitalStream replaced the activity of the former third party CDN service provider.  
 
Other Operating Expenses

Other than direct costs of network, sales and services, compensation and facilities-related costs have the most pervasive impact on operating expenses.  Compensation and benefits comprise the largest expenses after direct costs of network, sales and services. Cash-basis compensation and benefits increased $12.0 million to $53.4 million for the year ended December 31, 2007 from $41.4 million for the year ended December 31, 2006. Stock-based compensation increased $2.8 million to $8.7 million for the year ended December 31, 2007 from $5.9 million for the year ended December 31, 2006. All of the increases in compensation and benefits are primarily due to increased headcount, largely attributable to the additional employees resulting from the VitalStream acquisition.  For the year ended December 31, 2007, the additional VitalStream employees accounted for $6.6 million of the increase in cash-basis compensation and $1.3 million of the increase in stock-based compensation. Compensation also increased due to the hiring of other employees throughout the Company, including at the senior management level. Total headcount increased to 420 at December 31, 2007 compared to 330 at December 31, 2006.

As discussed in note 2 of the consolidated financial statements, we adopted SFAS No. 123R on January 1, 2006. Accordingly, total operating costs and expense and net income for 2007 and 2006 includes stock-based compensation expense in the following amounts:


 
Year Ended December 31,
 
 
2007
   
2006
 
Direct costs of customer support
$
1,892
   
$
1,102
 
Product development
 
856
     
628
 
Sales and marketing
 
2,135
     
2,145
 
General and administrative
 
3,798
     
2,067
 
Total stock-based compensation
$
8,681
   
$
5,942
 

Total unrecognized compensation costs related to non-vested stock-based compensation as of December 31, 2007 was $26.9 million with a weighted-average remaining recognition period of 2.8 years.

Cash-basis compensation and benefits decreased $1.5 million to $41.4 million for the year ended December 31, 2006 from $42.9 million for the year ended December 31, 2005, which reflects a net decrease in salaries and wages and a decrease in employee benefits, partially offset by a net increase in commissions. The decreases in compensation and benefits reflect a consistent headcount of approximately 330 full-time employees for both 2006 and 2005, but favorable experience on self-insured medical claims in 2006, while the increase in commissions is revenue driven. Compensation for the year ended December 31, 2006 also includes an increase of $1.8 million in employee bonuses over the year ended December 31, 2005.

Prior to the adoption of SFAS No. 123R on January 1, 2006, we utilized the disclosure-only provisions of SFAS No. 123 and accounted for stock-based compensation plans under the recognition and measurement provisions of APB Opinion No. 25 and related interpretations. Accordingly, we did not recognize any expense for options to purchase our common stock with an exercise price equal to fair market value at the date of grant for any periods prior to January 1, 2006.

45

 
Pro forma stock-based compensation expense as previously reported for 2005 was $9.7 million. The decrease of $3.8 million in recorded stock-based compensation expense for the year ended December 31, 2006 compared to the pro forma stock-based compensation expense for the year ended December 31, 2005 is due primarily to cancellations of outstanding stock options and the difference between estimated and actual forfeitures. SFAS No. 123R requires compensation expense to be recorded net of estimated forfeitures with a subsequent adjustment to reflect actual forfeitures as they occur. Previously, forfeitures of unvested stock options were accounted for on a pro forma basis as they were incurred, generally resulting in higher pro forma stock compensation than under the current provisions of SFAS No. 123R. In addition, a significant number of unvested stock options were forfeited upon the resignation of Mr. Gregory Peters, our former Chief Executive Officer, thus reducing the number of outstanding stock options for determining comparative stock-based compensation expense for the year ended December 31, 2006.

Overall, facility and related costs, including repairs and maintenance, communications and office supplies but excluding direct costs of network, sales and services, increased $1.0 million, or 17%, to $7.0 million for the year ended December 31, 2007 compared to $6.0 million for the year ended December 31, 2006. The increase is primarily due to $0.7 million of VitalStream post-acquisition operating costs.
 

Other significant operating costs are discussed with the financial statement captions below:

Direct costs of amortization of acquired technologies

Direct costs of amortization of acquired technologies increased $3.7 million from $0.5 million for the year ended December 31, 2006 to $4.2 million for the year ended December 31, 2007. The increase in amortization expense is due to the amortization of the post-acquisition intangible technology assets of VitalStream.

Direct costs of customer support>

Direct costs of customer support increased 43% from $11.6 million for the year ended December 31, 2006 to $16.5 million for the year ended December 31, 2007. The increase of more than $4.9 million was primarily due to compensation of employees and facilities-related costs as discussed above. VitalStream employees accounted for $1.7 million of added cash-basis compensation and benefits and $0.5 million of additional stock-based compensation for the year ended December 31, 2007. Other increases in cash-basis and stock-based compensation amounted to $1.3 million and $0.3 million, respectively, whereas facilities-related costs increased $0.6 million.

Direct costs of customer support increased 8% from $10.7 million for the year ended December 31, 2005 to $11.6 million for the year ended December 31, 2006. The increase of $0.9 million was primarily due to increases in costs related to stock-based compensation of $1.1 million, offset by decreased compensation and employee benefits of $0.7 million, as discussed above. In addition, facilities and related expenses increased $0.7 million based on more accurate data for allocation of costs, primarily from sales and marketing.

Product development

Product development costs for the year ended December 31, 2007 increased 47% to $6.6 million from $4.5 million for the year ended December 31, 2006. The increase of $2.1 million is primarily attributable to the addition of VitalStream employees and facilities-related costs. For the year ended December 31, 2007, the additional VitalStream employees accounted for $1.0 million of additional cash-basis compensation and benefits costs and $0.3 million of additional stock-based compensation costs. In addition, facilities-related costs amounted to $0.3 million of this increase.

46

 
Product development costs for the year ended December 31, 2006 decreased 8% to $4.5 million from $4.9 million for the year ended December 31, 2005. The decrease of $0.4 million is attributable to decreases in costs related to compensation and employee benefits of $0.5 million, outside professional services of $0.5 million and training expenses of $0.1 million. The decreases were offset by an increase in stock-based compensation expense of $0.6 million for the year ended December 31, 2006, as discussed above. The decrease in compensation and employee benefits partially reflects the redeployment of technical resources from product support to internal network support, which is accounted for in general and administrative expense. The decrease in outside professional services is primarily due to a specific project in 2005.

Sales and marketing

Sales and marketing costs for the year ended December 31, 2007 increased 16% to $31.5 million from $27.2 million for the year ended December 31, 2006. The increase of more than $4.3 million is primarily comprised of VitalStream employee costs. Cash-basis compensation, benefits and commissions related to VitalStream employees accounted for $2.8 million and stock-basis compensation for these employees amounted to $0.4 million for the year ended December 31, 2007.

Sales and marketing costs for the year ended December 31, 2006 increased 5% to $27.2 million from $25.9 million for the year ended December 31, 2005. The net increase of $1.3 million was primarily due to increases in stock-based compensation expense of $2.1 million and commissions of $1.6 million, offset by decreases in compensation and employee benefits expenses of $1.4 million, all of which were discussed above. Also, as discussed with direct costs of customer support above, facilities and related expenses decreased $0.7 million largely due to more accurate data allocations of expenses to direct costs of customer support. Outside professional services decreased $0.3 million and travel, entertainment and training expenses decreased $0.2 million. The decreases in outside professional services and training are the result of better utilization of internal resources while the decrease in travel and entertainment resulted from an effort to reduce less-essential travel. All of these reductions were partially offset by an increase of $0.3 million in marketing and advertising efforts during the year ended December 31, 2006.

General and administrative>

General and administrative costs for the year ended December 31, 2007 increased 47% to $32.5 million from $22.1 million for the year ended December 31, 2006. The increase of $10.4 million is primarily due to increases in cash-basis compensation and benefits, professional services and stock-based compensation. Cash-basis compensation and benefits for the year ended December 31, 2007 increased $3.6 million, including $1.0 million for the additional VitalStream employees. As discussed earlier, the other cause for the increase in cash-basis compensation is the hiring of other employees throughout the Company, including at the senior management level. The overall increase in head-count caused us to accrue employee bonuses $0.3 million higher during 2007 than we did for 2006 and caused higher self-insured medical claims of $0.6 million compared to 2006. Professional services for the year ended December 31, 2007 increased $2.0 million primarily due to consultation fees on our information technology systems, compliance activities for domestic and international tax and financial statement requirements, recruiting fees and contract labor to fill a number of open job requisitions, and legal fees, including those associated with new proxy disclosure requirements and ongoing litigation. Bad debt expense increased approximately $1.7 million to $2.2 million for the year ended December 31, 2007.  The increase in bad debt expense is due primarily to our integration of VitalStream with their legacy customers causing bad debt expense to be greater than our historical expense.  Stock-based compensation costs increased $1.7 million for the year ended December 31, 2007 due to annual grants of stock options and unvested restricted common stock to non-employee directors, the stock options assumed in the VitalStream acquisition and initial grants and awards to new members of senior management.

General and administrative costs for the year ended December 31, 2006 increased 10% to $22.1 million from $20.1 million for the year ended December 31, 2005. The increase of $2.0 million primarily reflects a $2.4 million increase in taxes (non-income based), licenses, fees, a $2.1 million increase in stock-based compensation expense, and a $1.1 million increase in compensation and employee benefits. These increases were offset by decreases in outside professional services of $0.9 million, bad debt expense of $0.9 million, facility and related expense of $0.9 million, a reduction of insurance and administrative expense of $0.3 million, and a reduction of training expense of $0.2 million. Part of the increase in cash-basis compensation and benefits is the redeployment of technical resources from product support as noted under the caption product development above.

47



The increases in compensation and benefits, including stock-based compensation, and the decrease in facility-related costs are discussed above. In addition, the decrease in outside professional services can be attributed to a number of factors, including focused cost control and better utilization of internal resources. Professional services for the year ended December 31, 2006 also includes $0.6 million related to an abandoned corporate development project.

Restructuring and asset impairment

As discussed in note 4 to the financial statements, we incurred a restructuring and asset impairment charge of $10.3 million during the three months ended March 31, 2007. The charge was the result of a review of our business, particularly in light of our acquisition of VitalStream and our plan to finalize the overall integration and implementation plan before the end of the first quarter. The charge to expense included $7.8 million for leased facilities, representing both the costs less anticipated sublease recoveries that will continue to be incurred without economic benefit to us and costs to terminate leases before the end of their term. The charge also included severance payments of $1.1 million for the termination of certain employees and $1.4 million for impairment of assets. Net related expenditures were estimated to be $10.7 million, of which $2.8 million has been paid during the year ended December 31, 2007, and the balance continuing through December 2016, the last date of the longest lease term.  These expenditures are expected to be paid out of operating cash flows. Cost savings from the restructuring were estimated to be approximately $0.8 million per year through 2016, primarily for rent expense.

We incurred a $1.1 million impairment charge during the three months ended March 31, 2007 for the sales order-through-billing system, which was a result of an evaluation of the existing infrastructure relative to our new financial accounting system and the acquisition of VitalStream.

Depreciation and amortization

For the year ended December 31, 2007, depreciation and amortization, including other intangible assets but excluding acquired technologies, increased 40% to $22.2 million compared to $15.9 million for the year ended December 31, 2006. The increase of $6.4 million primarily relates to post-acquisition depreciation and amortization of VitalStream property and equipment and acquired amortizable intangible assets, excluding amortization of acquired technologies. The VitalStream property and equipment and acquired amortizable intangible assets account for $5.8 million of the expense for the year ended December 31, 2007.  The remaining increase in depreciation and amortization relates to the expansion of P-NAPs and on-going expansion of data center facilities. The restructuring and asset impairment described above initially reduced depreciation and amortization by approximately $0.4 million per year, decreasing to $0 in 2009. The amortization of acquired technologies is included in its own caption and discussed above.

Depreciation and amortization, including other intangible assets, for the year ended December 31, 2006 increased 8% to $15.9 million compared to $14.7 million for the year ended December 31, 2005. The increase of $1.2 million was primarily attributed to an increased depreciable base of assets as we upgraded our P-NAP facilities and continue to expand our data center facilities.
 
48

 
Write-off of investment

We incurred a charge of $1.2 million representing the write-off of the remaining carrying value of our investment in series D preferred stock of Aventail Corporation, or Aventail. We made an initial cash investment of $6.0 million in Aventail series D preferred stock pursuant to an investment agreement in February 2000. In connection with a subsequent round of financing by Aventail, we recognized an initial loss on our investment of $4.8 million in 2001. On June 12, 2007, SonicWall, Inc. announced that it entered into an agreement to acquire Aventail for approximately $25.0 million in cash. The transaction closed on July 11, 2007, and all shares of series D preferred stock were cancelled and the holders of series D preferred stock did not receive any consideration for such shares. The write-off is included in non-operating (income) expense in the accompanying consolidated statement of operations.

Income taxes

The provision for income taxes was a net benefit of $3.1 million for the year ended December 31, 2007 and expense of $0.1 million for the year ended December 31, 2006. For the year ended December 31, 2007, the tax provision includes a $4.4 million benefit related to the release of the valuation allowance associated with our U.K. deferred tax assets.  The U.K. benefit is offset by a reserve of $0.9 million and a U.S. deferred tax liability relating to the VitalStream acquisition.

The reduction in valuation allowance was due to the existence of sufficient positive evidence as of December 31, 2007 to indicate that our net operating losses in the U.K. would more likely than not be realized in the future. The evidence primarily consists of the results of prior performance in the U.K. and the expectation of future performance based on historical results.  We will continue to assess in the future the recoverability of U.S. and other deferred tax assets, and whether or not the valuation allowance should be reduced relative to the U.S. and other deferred tax assets outside the U.K.


Cash Flows for the Years Ended December 31, 2007, 2006 and 2005

Net cash from operating activities.

Net cash provided by operating activities was $27.6 million for the year ended December 31, 2007.  Our net loss, adjusted for non-cash items, generated cash from operations of $32.1 million while changes in operating assets and liabilities, excluding effects of the VitalStream acquisition, represented a use of cash from operations of $4.5 million.  The primary non-cash adjustment was $26.4 million for depreciation and amortization, which includes the amortizable intangible assets acquired through the acquisition of VitalStream on February 20, 2007 and the expansion of our P-NAP and data center facilities throughout 2007. Non-cash adjustments also include $8.7 million for stock-based compensation expense, which is discussed above in the section captioned “Results of Operations.” The change in working capital includes an increase in accounts receivable of $15.8 million. The increase in accounts receivable results in quarterly days sales outstanding at December 31, 2007 increasing to 54 days from 38 days as of December 31, 2006. This increase in accounts receivable is largely due to revenue growth and also, in part, our day sales outstanding trending up from lower than historical levels at December 31, 2006.  We have also experienced some collection delays on certain larger, high credit quality customers that tend to pay over longer terms and in conjunction with the migration of some former VitalStream and other customers to Internap billing and systems platforms. We expect our quarterly days sales outstanding to improve over the next several quarters. The change in working capital also includes a net increase in accounts payable of $7.9 million due to the growth of our business, primarily attributed to the acquisition of VitalStream and our data center growth initiative. A portion of the increase is also caused by the implementation near year-end of a new telecommunications expense management system for our direct costs. We do not expect this implementation to have an impact on our accounts payable balance in the future. We anticipate continuing to generate cash flows from our results of operations, that is net income (loss) adjusted for non-cash items and manage changes in operating assets and liabilities towards a net $0 change over time in subsequent periods.  We also expect to use cash flows from operating activities to fund a portion of our capital expenditures and other requirements, to repay our outstanding debt as it becomes due and to meet our other commitments and obligations as they become due.

49

 
Net cash provided by operating activities was $29.6 million for the year ended December 31, 2006, and was primarily due to net income of $3.7 million adjusted for non-cash items of $25.4 million offset by changes in working capital items of $0.5 million. The changes in working capital items include net use of cash for accounts receivable of $1.7 million, inventory, prepaid expense and other assets of $1.8 million, and accrued restructuring of $1.5 million. These were offset by net sources of cash in accounts payable of $3.0 million, accrued liabilities of $1.4 million and deferred revenue of $1.1 million. The increase in receivables at December 31, 2006 compared to December 31, 2005 was related to the 18% increase in revenue. Quarterly days sales outstanding at December 31, 2006 decreased to 38 days from 43 days as of December 31, 2005. The increase in payables is primarily related to the timing of payments with the 2006 balance being consistent with our normal operating expenses and payment terms.

Net cash provided by operating activities was $5.5 million for the year ended December 31, 2005, and was primarily due to the net loss of $5.0 million adjusted for non-cash items of $19.7 million offset by changes in working capital items of $9.3 million. The changes in working capital items include net use of cash for accounts payable of $5.4 million, accounts receivable of $3.6 million, accrued restructuring of $1.9 million, and $0.2 million of inventory, prepaid expense and other assets. These were offset by net sources of cash in accrued liabilities of $0.8 million and deferred revenue of $1.0 million. The increase in receivables at December 31, 2005 compared to December 31, 2004 was related to the 6% increase in revenue. The decrease in payables is primarily related to a general decrease in expenses when compared to last year.
 

Net cash used in investing activities for the year ended December 31, 2007 was $36.4 million primarily due to capital expenditures of $30.3 million and net purchases of short-term investments of $6.1 million. Our capital expenditures were principally for the expansion of our data center facilities, CDN infrastructure and upgrading our P-NAP facilities and were funded from both cash from operations and borrowings from the new credit agreement we entered into on September 14, 2007. We discuss the credit agreement in greater detail in the section below captioned “Liquidity.”  Our forecast for capital expenditures in 2008 ranges from $45 - $50 million.  However, our credit agreement, discussed below, limits us to unfunded capital expenditures of $25.0 million per year. Investing activities for the year ended December 31, 2007 also includes purchases and sales of auction rate securities. While we have noted auction rate reset failures in the market and have experienced our own auction rate reset failures subsequent to year-end, we do not expect to incur any significant liquidity constraints in the current auction rate securities market and anticipate that, based on the nature of the underlying assets, we will be able to recover the full cost basis of the assets within one year.  

Net cash used in investing activities for the year ended December 31, 2006 was $10.4 million primarily due to capital expenditures of $13.4 million. Our capital expenditures were principally for upgrading our P-NAP facilities and the expansion of our data center facilities.

Net cash used in investing activities for the year ended December 31, 2005 was $9.4 million primarily due to capital expenditures of $10.2 million. Our capital expenditures were principally comprised of leasehold improvements related to the upgrade of several data center facilities.

Net cash from financing activities.

Net cash provided by financing activities for the year ended December 31, 2007 was $15.2 million. Cash provided by financing activities was primarily due to proceeds from note payable of $19.7 million, net of discount, and proceeds from stock compensation plan activity of $8.6 million, partially offset by the repayment of prior outstanding debt of $11.3 million and payments on capital leases of $1.6 million. The proceeds from note payable were a result of entering into the new credit agreement on September 14, 2007.  As a result of these activities, we had balances of $19.8 million in a note payable (net of discount) and $1.3 million in capital lease obligations as of December 31, 2007 with $3.2 million in the note payable and capital leases scheduled as due within the next 12 months. While we anticipate funding a large portion of our capital expenditures by drawing down on our credit facility, we expect to meet most of our cash requirements, including repayment of debt as it becomes due, through cash from operations, and as needed, cash on hand and short-term investments.  We may also utilize our revolving line of credit if we consider it economically favorable to do so.

50

 
Net cash provided by financing activities for the year ended December 31, 2006 was $2.0 million. Cash provided by financing activities was primarily due to proceeds from stock options, employee stock purchase plan and exercise of warrants of $6.8 million offset by principal payments on a note payable of $4.4 million and payments on capital lease obligations of $0.5 million. As a result of these activities, we had balances of $7.7 million in a note payable and $0.4 million in capital lease obligations as of December 31, 2006 with $4.7 million in the note payable and capital leases scheduled as due within the next 12 months.

Net cash used in financing activities for the year ended December 31, 2005 was $5.5 million. Cash used in financing activity included principal payments on notes payable of $6.5 million and payments on capital lease obligations of $0.5 million. These payments were partially offset by proceeds received from the exercise of stock options of $1.5 million. As a result of these activities, we had balances of $12.0 million in notes payable and $0.8 million in capital lease obligations as of December 31, 2005.


We recorded a net loss of $5.6 million of the year ended December 31, 2007 and net income of $3.7 million for the year ended December 31, 2006. As of December 31, 2007, our accumulated deficit was $862.0 million. Our net loss for the year ended December 31, 2007 includes $13.0 million in charges for restructuring, asset impairment, write-off of an investment, and acquired in-process research and development, none of which we expect to incur on a regular basis. We cannot guarantee that we will return to profitability given the competitive and evolving nature of the industry in which we operate. We may not be able to sustain or increase profitability on a quarterly basis, and our failure to do so would adversely affect our business, including our ability to raise additional funds.
 
We expect to meet our cash requirements in 2008 through a combination of net cash provided by operating activities, existing cash, cash equivalents and short-term investments in marketable securities, and borrowings under our credit agreement, especially for capital expenditures.  We expect to incur these capital expenditures primarily for the expansion of our P-NAP and data center facilities. We may also utilize our revolving line of credit, particularly if we consider it economically favorable to do so. Our capital requirements depend on a number of factors, including the continued market acceptance of our services and products, the ability to expand and retain our customer base and other factors. If our cash requirements vary materially from those currently planned, if our cost reduction initiatives have unanticipated adverse effects on our business or if we fail to generate sufficient cash flows from the sales of our services and products, we may require greater or additional financing sooner than anticipated. We can offer no assurance that we will be able to obtain additional financing on commercially favorable terms, or at all, and provisions in our existing credit agreement limit our ability to incur additional indebtedness. We believe we have sufficient cash to operate our business for the foreseeable future.

Short-term investments.  >Short-term investments primarily consist of high credit quality corporate debt securities, auction rate securities whose underlying assets are state-issued student and educational loans which are substantially backed by the federal government, commercial paper, and U.S. Government Agency debt securities. At December 31, 2007, our balance in short-term investments was $19.6 million, of which $7.2 million were auction rate securities carrying AAA/Aaa ratings as of December 31, 2007.  Auction rate securities are variable rate bonds tied to short-term interest rates with maturities on the face of the securities in excess of 90 days and have interest rate resets through a modified Dutch auction, at predetermined short-term intervals, usually every 7, 28 or 35 days.  They generally trade at par and are callable at par on any interest payment date at the option of the issuer.  Interest received during a given period is based upon the interest rate determined through the auction process.  Although these securities are issued and rated as long-term bonds, they are priced and traded as short-term instruments because of the liquidity provided through the interest rate reset.  We have also noted auction rate reset failures in the market and have experienced our own auction rate reset failures subsequent to year-end, however, we do not expect to incur any significant liquidity constraints and anticipate that, based on the nature of the underlying assets, we will be able to recover the full cost basis of the assets within one year. We expect to hold the auction rate securities until liquidity improves or the borrower calls the underlying securities. All short-term investments either (1) have original maturities greater than 90 days but less than one year or (2) are auction rate securities expected to be liquidated within one year, are classified as available for sale, and reported at fair value.

51

 
Credit agreement.  > On September 14, 2007, we entered into a $35.0 million credit agreement, or the Credit Agreement, with Bank of America, N.A., as administrative agent, and lenders who may become a party to the Credit Agreement from time to time.  VitalStream Holdings, Inc., VitalStream, Inc., PlayStream, Inc., and VitalStream Advertising Services, Inc., four of our subsidiaries, are guarantors of the Credit Agreement.

The Credit Agreement replaced the prior credit agreement, a $5.0 million revolving credit facility and a $17.5 million term loan, which was evidenced by a Loan and Security Agreement between the Company and Silicon Valley Bank that was last amended on December 27, 2005.  We paid off and terminated this prior credit  agreement concurrently with the execution of the Credit Agreement.

Our obligations under the Credit Agreement are pledged, pursuant to a pledge and security agreement and an intellectual property security agreement by a security interest granted in substantially all of our assets including the capital stock of our domestic subsidiaries and 65% of the capital stock of our foreign subsidiaries.

The Credit Agreement provides for a four-year revolving credit facility, or the Revolving Credit Facility, in the aggregate amount of up to $5.0 million which includes a $5.0 million sub-limit for letters of credit.  With the prior approval of the administrative agent, we may increase the total commitments by up to $15.0 million for a total commitment under the Revolving Credit Facility of $20.0 million.  The Revolving Credit Facility is available to finance working capital, capital expenditures and other general corporate purposes. As December 31, 2007, no amounts were outstanding on the Revolving Credit Facility.

The Credit Agreement also provides for a four-year term loan, or the Term Loan, in the amount of $30.0 million.  We borrowed $20.0 million concurrently with the closing and used a portion of the proceeds from the Term Loan to pay off our prior credit facility.  We intend to use the remaining proceeds to fund capital expenditures related to the expansion of our data center facilities.

The interest rate on the Revolving Credit Facility and Term Loan is a tiered LIBOR-based rate that depends on our 12-month trailing EBITDA. As of December 31, 2007, the interest rate was 7.075%.

We will only pay interest on the Term Loan during the first 12 months of its four-year term.  Commencing on the last day of the first calendar quarter after the first anniversary of the closing, the outstanding amount of the Term Loan will amortize on a straight-line schedule with the payment of 1/16 of the original principal amount of the Term Loan due quarterly.  We will pay all unpaid amounts at maturity, which is September 14, 2011.

The Credit Agreement includes customary representations, warranties, negative and affirmative covenants, including certain financial covenants relating to net funded debt to EBITDA ratio and fixed charge coverage ratio, as well as customary events of default and certain default provisions that could result in acceleration of the Credit Agreement.  As of December 31, 2007, we were in compliance with the financial and other covenants.

The net proceeds received from the Term Loan were reduced by $0.3 million for fees paid to Bank of America and its agents. We treated these fees as a debt discount and will amortize the fees to interest expense using the interest method over the term of the loan. We recorded less than $0.1 million of related amortization during the year ended December 31, 2007. As of December 31, 2007, the balance on the Term Loan, net of the discount, was $19.8 million. We incurred other costs of less than $0.1 million in connection with entering into the Credit Agreement, which were recorded as debt issue costs and will amortize over the term of the Credit Agreement.

52

 
As a result of the transactions discussed above, we recorded a loss on extinguishment of debt of less than $0.1 million during the year ended December 31, 2007. The loss on extinguishment of debt is included in Other, net in the non-operating (income) expense section of the consolidated statements of operations.

Also during the year ended December 31, 2007, we paid off the term loans and line of credit issued pursuant to the loan and security agreement assumed in the VitalStream acquisition.

Capital leases.> Our future minimum lease payments on remaining capital lease obligations at December 31, 2007 totaled $1.4 million.

Commitments and other obligations.> We have commitments and other obligations that are contractual in nature and will represent a use of cash in the future unless there are modifications to the terms of those agreements. Network commitments primarily represent purchase commitments made to our largest bandwidth vendors and contractual payments to license data center space used for resale to customers. Our ability to improve cash used in operations in the future would be negatively impacted if we do not grow our business at a rate that would allow us to offset the service commitments with corresponding revenue growth.
 


   
Payments Due by Period
   
   
Total
 
Less than
1 year
 
1- 3
Years
 
3-5
Years
 
More
than 5
years
   
                         
Note payable(1)
 
$
23,815
 
$
3,980
 
$
11,980
 
$
7,855
 
$
   
Capital lease obligations
   
1,392
   
922
   
470
   
   
   
Operating lease commitments
   
220,894
   
28,211
   
50,689
   
53,208
   
88,786
   
Service commitments
   
22,014
   
12,167
   
9,847
   
   
   
                                   
   
$
268,115
 
$
45,280
 
$
72,986
 
$
61,063
 
$
88,786
   
   
 
(1)
As noted in the section captioned “Credit Agreement” under this Item 7, the interest rate on the Term Loan is a tiered LIBOR-based rate that depends on our 12-month trailing EBITDA as defined in the Credit Agreement. As of December 31, 2007, the interest rate was 7.075%. The projected interest included in the debt payments above incorporates this rate.
 
Common and preferred stock. >Our Certificate of Incorporation includes designation for 3.5 million shares of preferred stock, which includes 0.5 million shares of series B preferred stock. As of December 31, 2007, no shares of preferred stock were issued or outstanding.

We issued approximately 12.2 million shares of our common stock to the former stockholders of VitalStream in connection with the acquisition, which closed on February 20, 2007.

On July 10, 2006, we implemented a one-for-ten reverse stock split and amended our Certificate of Incorporation to reduce our authorized shares from 600 million to 60 million. We began trading on a post-reverse split basis on July 11, 2006. All share and per share information herein (including shares outstanding, earnings per share and warrant and stock option data) have been retroactively adjusted for all periods presented to reflect this reverse split.
 
53

 
In June 2006, our stockholders approved a measure to reprice certain outstanding options under our existing equity incentive plans. Options with an exercise price per share greater than or equal to $13.00 were eligible for the repricing. The repricing was implemented through an exchange program under which eligible participants were offered the opportunity to exchange their eligible options for new options to purchase shares. Each new option had substantially the same terms and conditions as the eligible options cancelled except as follows:

 
·
The exercise price per share of each replacement option granted in the exchange offer was $14.46, the average of the closing prices of the common stock as reported by the American Stock Exchange and the NASDAQ Global Market, as applicable, for the 15 consecutive trading days ending immediately prior to the grant date of the replacement options;
 
 
·
For all eligible options with an exercise price per share greater than or equal to $20.00, the exchange ratio was 1-for-2; and
 
 
·
Each new option has a three-year vesting period, vesting in equal monthly installments over three years, so long as the grantee continues to be a full-time employee of the company and a ten-year term.
 
 
As discussed in note 15 to the consolidated financial statements, warrants to purchase approximately 34,000 shares of our common stock at a weighted exercise price of $9.50 per share were outstanding as of December 31, 2007.
  
 
Short-term investments in marketable securities>. Short-term investments primarily consist of high credit quality corporate debt securities, auction rate securities whose underlying assets are state-issued student and educational loans which are substantially backed by the federal government, commercial paper, and U.S. Government Agency debt securities. All of our investments have original maturities greater than 90 days but less than one year, except for investments in auction rate securities, further discussed below. All short-term investments are classified as available for sale and reported at fair value. Due to the short-term nature of our investments in marketable securities, we do not believe there is any material exposure to market risk changes in interest rates.   We estimate that a change in the effective yield of 100 basis points would change our interest income by less than $0.2 million per year.

Auction rate securities are variable rate bonds tied to short-term interest rates with maturities on the face of the securities in excess of 90 days and have interest rate resets through a modified Dutch auction, at predetermined short-term intervals, usually every 7, 28 or 35 days.  Auction rate securities generally trade at par and are callable at par on any interest payment date at the option of the issuer.  Interest received during a given period is based upon the interest rate determined through the auction process.  Although these securities are issued and rated as long term bonds, they are priced and traded as short-term instruments because of the liquidity provided through the interest rate resets.  Uncertainties in the credit markets may affect the liquidity of our holdings in auction rate securities.  We did not experience any unsuccessful auction rate resets during the year ended or the initial rate resets immediately following December 31, 2007, however, we have experienced failures on each of our subsequent auction rate resets.  Nevertheless, we continue to receive interest every 28-35 days. While our investments are of high credit quality, at this time we are uncertain as to whether or when the liquidity issues relating to these investments will worsen or improve. We do not expect to incur any significant liquidity constraints and anticipate that, based on the nature of the underlying assets, we will be able to recover the full cost basis of the assets within one year.  Therefore, we do not believe that adjusting the fair value of our portfolio of auction rate securities is necessary at this time. We expect to hold the auction rate securities until liquidity improves or the borrower calls the underlying securities. In the meantime, we believe we have sufficient liquidity through our cash balances, other short-term investments and available credit. As of December 31, 2007, we have a total of $7.2 million invested in auction rate securities.
 
54

 
Other investments>. We have invested $4.1 million in Internap Japan, our joint venture with NTT-ME Corporation and NTT Holdings. We account for this investment using the equity-method and to date we have recognized $3.3 million in equity-method losses, representing our proportionate share of the aggregate joint venture losses and income. Furthermore, the joint venture investment is subject to foreign currency exchange rate risk. The market for services offered by Internap Japan has not been proven and may never materialize.

 
 
2008
 
2009
 
2010
 
2011
 
Fair
Value
Long-term debt:
                                     
Term loan
 $
 2,500
   
$
5,000
   
$
5,000
   
$
7,500
   
$
20,000
 
Interest rate
 
7.075
%
   
7.075
%
   
7.075
%
   
7.075
%
   
7.075
%
Foreign currency risk>. Substantially all of our revenue is currently in U.S. dollars and from customers primarily in the U.S. We do not believe, therefore, that we currently have any significant direct foreign currency exchange rate risk.
 
 
Our consolidated financial statements, financial statement schedule and the report of the independent registered public accounting firm appear in Part IV of this annual report on Form 10-K/A.  Our report on internal controls over financial reporting appear in Item 9A of this annual report on Form 10-K/A.
 
 
None.

 
Evaluation of Disclosure Controls and Procedures
 
Our management, with the participation of our Chief Executive Officer and Principal Accounting Officer, evaluated the effectiveness of our disclosure controls and procedures as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as of December 31, 2007.  Our disclosure controls and procedures are designed to ensure that information we are required to disclose in the reports we file or submit under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Principal Accounting Officer, as appropriate, to allow timely decisions regarding required disclosures, and is recorded, processed, summarized, and reported within the time periods specified in the SEC's rules and forms.  Based upon the evaluation described above our Chief Executive Officer and Principal Accounting Officer concluded that, as of December 31, 2007, our disclosure controls and procedures were not effective because of the material weakness described below in Management's Report on Internal Control Over Financial Reporting.

Background

During its review of sales credit activity subsequent to year end, management identified the activity as an area for further review and investigation. Management concluded that an investigation was appropriate to identify the underlying cause and to obtain completeness, accuracy, valuation, and disclosure of sales adjustments. This investigation caused the Company to file this annual report on  Form 10-K late.

Management’s Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f).
 
We assessed the effectiveness of our internal control over financial reporting as of December 31, 2007. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control — Integrated Framework. 

A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company's annual or interim financial statements will not be prevented or detected on a timely basis.

Management identified the following material weakness in our internal control over financial reporting as of December 31, 2007:

We did not maintain effective controls over the completeness, accuracy, valuation, and disclosure of sales adjustments. Specifically, we did not maintain effective controls, including controls over the analysis of requests for sales credits and billing adjustments, to provide timely information for management to assess the completeness, accuracy, valuation, and disclosure of sales adjustments.  This control deficiency resulted in the misstatement of our revenue, net accounts receivable and related financial disclosures, and in the revision of the Company’s consolidated financial statements for the quarter ended September 30, 2007 and in an adjustment to the consolidated financial statements for the quarter ended December 31, 2007. Additionally, this control deficiency could result in misstatements of the aforementioned accounts and disclosures that would result in a material misstatement of the consolidated financial statements that would not be prevented or detected. Accordingly, our management has determined that this control deficiency constitutes a material weakness.

As a result of the material weakness described above, management concluded that our internal control over financial reporting was not effective as of December 31, 2007 based on the criteria established in Internal Control - Integrated Framework issued by the COSO.
 
The effectiveness of our internal control over financial reporting as of December 31, 2007 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report, which is included herein.

 
55

 
Plan for Remediation of the Material Weakness

To remediate the material weakness described above and to enhance our internal control over financial reporting, management implemented plans in the first quarter of 2008, or will supplement plans during 2008, to  its existing controls for the analysis of requests for sales adjustments, which may include but are not limited to, the following additional processes and controls:

 
·
A single, common logging system for customers to record all disputes, disconnects and requests for credits,
 
·
A weekly review of a customer request log with appropriate designated management and approval pursuant to the schedule of authorization,
 
·
A more robust, proactive tracking of customer usage patterns and overall customer satisfaction, and
 
·
Perform a review by the appropriate designated finance management of the accounting estimates developed from the relevant, sufficient, and reliable data collected above

Notwithstanding the material weakness, management believes that the financial statements included in this report fairly present in all material respects our financial position, results of operations and cash flows for the periods presented.

Changes in Internal Control Over Financial Reporting

No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the quarter ended December 31, 2007 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
  
 
None.


56

 
 
PART III
 
 
Our Executive Officers and Directors
 
    The following table sets forth information regarding our executive officers and Directors as of December 31, 2007.
 
         
Name