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SCHEDULE 14C INFORMATION
Information Statement Pursuant to Section 14(c)
of the Securities Exchange Act of 1934

Check the appropriate box:

þ   Preliminary Information Statement
o   Confidential, for Use of the Commission Only (as permitted by Rule 14c-5(d)(2))
o   Definitive Information Statement

NAVISITE, INC.


(Name of Registrant as Specified in Charter)

Payment of Filing Fee (Check the appropriate box):

þ   No fee required.
o   Fee computed on table below per Exchange Act Rule 14c-5(g) and 0-11.

1)   Title of each class of securities to which transaction applies:
 
   
 
2)   Aggregate number of securities to which transaction applies:
 
   
 
3)   Per unit price or other underlying value of transaction computed pursuant to Exchange Act Rule 0-11 (set forth the amount on which the filing fee is calculated and state how it was determined):
 
   
 
4)   Proposed maximum aggregate value of transaction:
 
   
 
5)   Total fee paid:
 
   

o   Fee paid previously by written preliminary materials.
o   Check box if any part of the fee is offset as provided by Exchange Act Rule 0-11(a)(2) and identify the filing for which the offsetting fee was paid previously. Identify the previous filing by registration statement number, or the Form or Schedule and the date of its filing.

1)   Amount Previously Paid:
 
   
 
2)   Form Schedule or Registration Statement No.:
 
   
 
3)   Filing Party:
 
   
 
4)   Date Filed:
 
   


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Preliminary Copy

NAVISITE, INC.

400 Minuteman Road
Andover, Massachusetts 01810


 
NOTICE OF ACTION TAKEN PURSUANT TO
WRITTEN CONSENT OF STOCKHOLDERS


To the stockholders of NaviSite, Inc.:

      This Notice and the accompanying Information Statement are being furnished to the stockholders of NaviSite, Inc., a Delaware corporation (the “Company”), in connection with action taken by the holders of at least a majority of the issued and outstanding voting securities of the Company, approving, by written consent dated May 6, 2004, the following corporate actions:

        1.     The issuance of (i) 3,000,000 shares of the Company’s Common Stock to Surebridge, Inc., and (ii) the shares of the Company’s Common Stock issuable upon the conversion of convertible promissory notes made by the Company to Surebridge, Inc.; and
 
        2.     The amendment of the Company’s Amended and Restated 2003 Stock Incentive Plan to increase the maximum number of shares of the Company’s Common Stock available for issuance thereunder from 3,800,000 to 6,800,000 shares.

      We are not asking you for a proxy and you are requested not to send us a proxy.

      Your vote or consent is not requested or required to approve these matters. The accompanying Information Statement is provided solely for your information. The accompanying Information Statement also serves as the notice required by Section 228 of the Delaware General Corporation Law of the taking of a corporate action without a meeting by less than unanimous written consent of the stockholders of the Company.

  By Order of the Board of Directors,
 
  -s- Kenneth Drake
 
  KENNETH DRAKE
  Secretary

Andover, Massachusetts

July [     ], 2004


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NOTICE OF ACTION TAKEN PURSUANT TO WRITTEN CONSENT OF STOCKHOLDERS
INFORMATION STATEMENT
APPROVAL OF THE ISSUANCE OF THE FIXED SHARES AND THE CONVERSION SHARES
APPROVAL OF THE STOCK PLAN AMENDMENT
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
ADDITIONAL INFORMATION ABOUT NAVISITE
SUMMARY COMPENSATION TABLE
STOCK OPTION GRANTS IN THE FISCAL YEAR ENDED JULY 31, 2003
AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END OPTION VALUES
CONSOLIDATED BALANCE SHEETS
CONSOLIDATED STATEMENTS OF OPERATIONS
CONSOLIDATED STATEMENTS OF CASH FLOWS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


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Preliminary Copy

NAVISITE, INC.

400 Minuteman Road
Andover, Massachusetts 01810


 
INFORMATION STATEMENT


We are not asking you for a proxy and you are requested not to send us a proxy.

General

      This Information Statement is being furnished by NaviSite, Inc., a Delaware corporation (“NaviSite” or the “Company”), in connection with action taken by the holders of at least a majority of the issued and outstanding voting securities of the Company, approving, by written consent dated May 6, 2004, the following corporate actions:

        1.       The issuance of (i) 3,000,000 shares of the Company’s Common Stock, $.01 par value per share (the “Common Stock”), to Surebridge, Inc., and (ii) the shares of the Company’s Common Stock issuable upon the conversion of convertible promissory notes made by the Company to Surebridge, Inc.; and
 
        2.       The amendment of the Company’s Amended and Restated 2003 Stock Incentive Plan to increase the maximum number of shares of the Company’s Common Stock available for issuance thereunder from 3,800,000 to 6,800,000 shares.

      This Information Statement is being provided pursuant to the requirements of Rule 14c-2 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), to inform holders of Common Stock entitled to vote or give an authorization or consent in regard to the matters acted upon by written consent. This Information Statement is being mailed on or about July [     ], 2004, to the Company’s stockholders of record as of May 6, 2004 (the “Record Date”). The Company anticipates that the actions will take effect on August [     ], 2004.

      All share numbers and share prices provided in this Information Statement have been adjusted to reflect all stock splits effected prior to the Record Date, including the 1-for-15 reverse stock split of the Common Stock effected on January 7, 2003.

Reason for the Written Consent

 
The Surebridge Acquisition

      On June 10, 2004, the Company completed the acquisition of substantially all of the assets and liabilities of Surebridge, Inc. (“Surebridge”), a privately held provider of managed application services for mid-market companies, pursuant to the terms of an asset purchase agreement (as amended, the “Asset Purchase Agreement”).

      Under the terms of the Asset Purchase Agreement, the Company acquired substantially all of the assets of Surebridge in exchange for two promissory notes in the aggregate principal amount of approximately $39.3 million, three million shares of Common Stock (the “Fixed Shares”) and the assumption of certain liabilities of Surebridge at closing.

      The promissory notes issued by the Company to Surebridge consist of a Primary Note and an Escrow Note (collectively, the “Notes”). The Primary Note is in the principal amount of approximately


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$32.5 million. The Escrow Note is in the principal amount of approximately $6.8 million and has been deposited into escrow for the purpose of satisfying indemnification claims by the Company pursuant to the Asset Purchase Agreement. The principal amount of both Notes is subject to adjustment based on the net working capital of Surebridge at closing.

      The Notes accrue interest on the unpaid balance at an annual rate of 10%, however no interest shall accrue on any principal paid within nine months of the closing. The Notes shall be paid in full no later than the second anniversary of the closing. In the event that the Company realizes net proceeds in excess of $1 million from certain equity or debt financings or sales of assets, the Company is obligated to use a significant portion of the proceeds to make payments on the Notes.

      The outstanding principal and accrued interest of the Notes shall be convertible into shares of Common Stock (the “Conversion Shares”) at the election of the holder (i) at any time following the first anniversary of the closing if the aggregate principal outstanding under the Notes at such time is greater than or equal to $20 million, (ii) at any time following the 18-month anniversary of the closing if the aggregate principal outstanding under the Notes at such time is greater than or equal to $10 million, (iii) at any time following the second anniversary of the closing, and (iv) at any time following an event of default thereunder. The conversion price of each Note is $4.642, which is the average closing price of the Common Stock for the ten-day period ending one day prior to closing.

      For a period of one year following the closing of the acquisition, Surebridge shall not sell, transfer, assign, convey, encumber, gift, distribute or otherwise dispose of the Fixed Shares, the Conversion Shares or the Notes; provided, however, if the Company does not make certain payments under the Notes or otherwise suffers an event of default thereunder, Surebridge may sell the Fixed Shares and the Conversion Shares at any time thereafter.

      The Fixed Shares and the Conversion Shares have certain demand and piggyback registration rights pursuant to a Registration Rights Agreement entered into by and between the Company and Surebridge.

     The Stock Plan Amendment

      On May 6, 2004, the Board of Directors of the Company approved, subject to stockholder approval, an amendment (the “Stock Plan Amendment”) to the Company’s Amended and Restated 2003 Stock Incentive Plan, to increase the maximum number of shares of Common Stock pursuant to which the Company may grant stock options and restricted stock awards thereunder from 3,800,000 to 6,800,000 shares.

     The Written Consent

      On May 6, 2004, Atlantic Investors, LLC, the majority stockholder of the Company (“Atlantic Investors”), delivered to the Company an executed written consent of stockholders, in the form attached as Appendix I, approving (i) the issuance of the Fixed Shares and the Conversion Shares, and (ii) the Stock Plan Amendment.

Voting and Vote Required

      The Company is not seeking consent, authorizations or proxies from you. Section 228 of the Delaware General Corporation Law (“Section 228”) provides that the written consent of the holders of outstanding shares of voting capital stock, having not less than the minimum number of votes which would be necessary to authorize or take such action at a meeting at which all shares entitled to vote thereon were present and voted, may be substituted for a meeting. Approval of at least a majority of the outstanding shares of Common Stock present and voting on the matter at a meeting would be required to approve each of (i) the issuance of the Fixed Shares and the Conversion Shares, and (ii) the Stock Plan Amendment.

      As of the Record Date, the Company had 24,829,228 shares of Common Stock outstanding and entitled to vote. Each share of Common Stock is entitled to one vote. On the Record Date, Atlantic Investors held 17,292,550 shares, or approximately 69.6%, of the Company’s Common Stock. Accordingly,

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the matters approved by Atlantic Investors by written consent on the Record Date have been approved under Section 228 and require no further stockholder action.

Notice Pursuant to Section 228

      Pursuant to Section 228, the Company is also required to provide prompt notice of the taking of a corporate action by written consent to the stockholders who have not consented in writing to such action. This Information Statement also serves as the notice required by Section 228.

Dissenters’ Rights of Appraisal

      The Delaware General Corporation Law does not provide dissenters’ rights of appraisal to the Company’s stockholders in connection with the matters approved by written consent.

Householding of Stockholder Materials

      Some banks, brokers and other nominee record holders may be participating in the practice of “householding” stockholder materials, such as proxy statements, information statements and annual reports. This means that only one copy of this Information Statement may have been sent to multiple stockholders in your household. The Company will promptly deliver a separate copy of this Information Statement to you if you write or call us at the following address or telephone number: Investor Relations Department, NaviSite, Inc., 400 Minuteman Road, Andover, Massachusetts 01810, telephone: (888) 298-8222. If you want to receive separate copies of stockholder materials in the future, or if you are receiving multiple copies and would like to receive only one copy for your household, you should contact your bank, broker, or other nominee record holder, or you may contact NaviSite at the above address and telephone number.

APPROVAL OF THE ISSUANCE OF THE FIXED SHARES AND THE CONVERSION SHARES

 
The Surebridge Acquisition

      On June 10, 2004, the Company completed the acquisition of substantially all of the assets and liabilities of Surebridge, a privately held provider of managed application services for mid-market companies. Under the terms of the Asset Purchase Agreement, the Company acquired substantially all of the assets of Surebridge in exchange for two promissory notes in the aggregate principal amount of approximately $39.3 million, the Fixed Shares and the assumption of certain liabilities of Surebridge at closing.

      The Primary Note is in the principal amount of approximately $32.5 million. The Escrow Note is in the principal amount of approximately $6.8 million and has been deposited into escrow for the purpose of satisfying indemnification claims by the Company pursuant to the Asset Purchase Agreement. The principal amount of both Notes is subject to adjustment based on the net working capital of Surebridge at closing. The Notes accrue interest on the unpaid balance at an annual rate of 10%, however no interest shall accrue on any principal paid within nine months of the closing. The Notes shall be paid in full no later than the second anniversary of the closing. In the event that the Company realizes net proceeds in excess of $1 million from certain equity or debt financings or sales of assets, the Company is obligated to use a significant portion of the proceeds to make payments on the Notes.

      The outstanding principal and accrued interest of the Notes shall be convertible into the Conversion Shares at the election of the holder (i) at any time following the first anniversary of the closing if the aggregate principal outstanding under the Notes at such time is greater than or equal to $20 million, (ii) at any time following the 18-month anniversary of the closing if the aggregate principal outstanding under the Notes at such time is greater than or equal to $10 million, (iii) at any time following the second anniversary of the closing, and (iv) at any time following an event of default thereunder. The conversion price of each Note is $4.642, which is the average closing price of the Common Stock for the ten-day

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period ending one day prior to closing. Assuming no principal adjustments, prepayments or successful indemnification claims by the Company, the maximum number of Conversion Shares issuable upon conversion of the Notes at the maturity date is approximately 10,235,528 shares.

      For a period of one year following the closing of the acquisition, Surebridge shall not sell, transfer, assign, convey, encumber, gift, distribute or otherwise dispose of the Fixed Shares, the Conversion Shares or the Notes; provided, however, if the Company does not make certain payments under the Notes or otherwise suffers an event of default thereunder, Surebridge may sell the Fixed Shares and the Conversion Shares at any time thereafter.

      The Fixed Shares and the Conversion Shares have certain demand and piggyback registration rights pursuant to a Registration Rights Agreement entered into by and between the Company and Surebridge.

 
Nasdaq Stockholder Approval Requirements

      The Common Stock is listed on The Nasdaq SmallCap Market. The NASD rules governing Nasdaq require stockholder approval of any issuance of securities (i) in connection with the acquisition of the stock or assets of another company that will or potentially will result in the issuance of shares representing 20% or more of the issuer’s outstanding shares of common stock or voting power prior to the issuance of such securities, or (ii) that will or potentially will result in a change of control of the issuer.

      Specifically, NASD Rule 4350(i)(1)(C) requires that the issuer of stock in connection with the acquisition of the stock or assets of another company secure stockholder approval prior to an issuance where the issuance or potential issuance of the shares of common stock, or securities convertible into or exercisable for common stock, would result in the issuance of 20% or more of the common stock or voting power of the issuer before the issuance. In addition, NASD Rule 4350(i)(1)(B) requires that the issuer of stock secure stockholder approval prior to an issuance or potential issuance which will result in a change of control of the issuer.

      Nasdaq rules do not require stockholder approval of the acquisition of the assets and liabilities of Surebridge by the Company or the issuance of the Fixed Shares or the Notes. However, the potential issuance of the Conversion Shares upon conversion of the Notes, when added to the issuance of the Fixed Shares, would potentially equal or exceed the 20% threshold and could potentially be deemed a change of control of the Company under applicable Nasdaq rules. Therefore, for purposes of the applicable Nasdaq rules, the Company’s stockholders approved the issuance of the Fixed Shares and the Conversion Shares prior to any issuance which would equal or exceed the 20% threshold or be deemed a change of control of the Company.

      On May 6, 2004, Atlantic Investors delivered to the Company an executed written consent of stockholders approving the issuance of the Fixed Shares and the Conversion Shares. This Information Statement is being sent to all stockholders of the Company as notice that such action has been taken. The Company is not asking that you vote to approve the issuance of the Fixed Shares and the Conversion Shares. Under federal law governing the taking of stockholder action by written consent, stockholder approval of the issuance of the Fixed Shares and the Conversion Shares will be deemed effective 20 days after the mailing of this Information Statement to stockholders of the Company. Pursuant to the terms of the Asset Purchase Agreement, the Notes shall not be convertible into an aggregate number of shares of Common Stock that is greater than or equal to (i) 19.9% of that number of shares of Common Stock outstanding immediately prior to the closing less (ii) 3,000,000 shares, unless and until such stockholder approval is deemed effective.

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APPROVAL OF THE STOCK PLAN AMENDMENT

      On May 6, 2004, the Board of Directors of the Company approved, subject to stockholder approval, an amendment to the Company’s Amended and Restated 2003 Stock Incentive Plan (as amended, the “2003 Plan”), to increase the maximum number of shares of Common Stock pursuant to which the Company may grant stock options and restricted stock awards thereunder from 3,800,000 to 6,800,000 shares. The Board adopted the Stock Plan Amendment because the number of shares currently available under the 2003 Plan is insufficient to satisfy the expected foreseeable future share requirements thereunder. The Board of Directors believes that continued grants of stock options, as well as grants of restricted stock awards, will be an important element in attracting and retaining key employees who are expected to contribute to the Company’s growth and success. NaviSite’s management relies on stock options as essential parts of the compensation packages necessary for NaviSite to attract and retain experienced officers and employees. As of May 6, 2004 and following approval by the stockholders of the Stock Plan Amendment, 3,017,691 shares were available for issuance under the 2003 Plan. The closing price of NaviSite Common Stock on May 6, 2004 was $5.20.

 
Summary of the 2003 Plan

      The 2003 Plan was adopted, subject to stockholder approval, by NaviSite’s Board of Directors on July 10, 2003, and amended and restated on November 11, 2003 to increase the number of shares of Common Stock available for issuance under such plan from 2,600,000 to 3,800,000. The 2003 Plan was approved by the stockholders of the Company on December 9, 2003 at the Annual Meeting of Stockholders. The 2003 Plan provides for the grant of options that are intended to qualify as incentive stock options within the meaning of Section 422 of the Code, options not intended to qualify as incentive stock options and restricted stock awards (each, an “Award”) to NaviSite’s employees, officers and directors, consultants or advisors. Incentive stock options may be granted only to employees of NaviSite. A maximum of 6,800,000 shares of Common Stock are eligible for issuance under the 2003 Plan upon the exercise of options or in connection with Awards. If any Award expires, or is terminated, surrendered or canceled without having been fully exercised or forfeited, in whole or in part (including as a result of shares of Common Stock being repurchased by NaviSite at the original issue price pursuant to a contractual repurchase right), or results in the Common Stock not being issued, the unissued Common Stock covered by such Award shall again be available for the grant of Awards under the 2003 Plan.

      As of May 6, 2004, approximately 397 persons were eligible to receive Awards under the 2003 Plan, including the Company’s five executive officers and three non-employee directors. The granting of Awards under the 2003 Plan is discretionary, and the Company cannot now determine the number or type of Awards to be granted in the future to any particular person or group of persons. The following table summarizes options awarded under the 2003 Plan as of May 6, 2004 to designated individuals and groups since the adoption of the 2003 Plan in July 2003:

           
Number of
Name and Principal Position Options Granted


Arthur P. Becker
       
 
Chief Executive Officer and President
    460,000  
Gabriel Ruhan
       
 
Chief Operating Officer
    460,000  
Patricia Gilligan
       
 
Former Chief Executive Officer
     
Kevin H. Lo
       
 
Former Chief Financial Officer and Former Senior Vice President of Finance and Strategy
     
Current Executive Officers, as a group
    1,160,000  
Current Non-Executive Officer Directors, as a group
    170,000  
Non-Executive Officer Employees, as a group
    2,765,125  

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      The purpose of the 2003 Plan is to provide Awards to employees, officers, directors, consultants and advisors of NaviSite and its present or future parent or subsidiary corporations (each a “Participant”), all of whom are eligible to receive Awards under the 2003 Plan. A copy of the 2003 Plan is attached to this Information Statement as Appendix II. The following is a summary of the 2003 Plan and should be read together with the 2003 Plan. The summary is qualified in its entirety by reference to the 2003 Plan.

      Administration. The 2003 Plan is administered by the Board of Directors. The Board of Directors has the power to grant Awards and to adopt, amend and repeal such administrative rules, guidelines and practices relating to the 2003 Plan as it may deem advisable. The Board of Directors may correct any defect, supply any omission or reconcile any inconsistency in the 2003 Plan or any Award in the manner and to the extent it shall deem expedient to carry the 2003 Plan into effect and it shall be the sole and final judge of such expediency. All decisions by the Board shall be made in the Board’s sole discretion and shall be final and binding on all persons having or claiming any interest in the Plan or in any Award. The Board may delegate its powers to one or more committees of the Board or to one or more executive officers of NaviSite (provided, that the Board of Directors shall fix the terms of the Awards granted by the executive officer and the maximum number of shares that the executive officer may grant and that no executive officer shall have the power to grant Awards to another executive officer (as defined in Rule 3b-7 of the Exchange Act, or to any officer (as defined in Rule 16a-1 of the Exchange Act) of NaviSite).

      Per-Participant Limit. No Participant may be granted Awards during any one calendar year to purchase more than 650,000 shares of Common Stock.

      Exercise Price. The Board establishes the exercise price at the time each option is granted.

      Exercise of Options. Each option granted under the 2003 Plan shall either be fully exercisable at the time of grant or shall become exercisable in such installments as the Board may specify. Once an installment becomes exercisable it shall remain exercisable until expiration or termination of the option, unless otherwise specified by the Board. Each option or installment may be exercised at any time or from time to time, in whole or in part, for up to the total number of shares with respect to which it is then exercisable. During the Participant’s lifetime, Awards may be exercised only by the Participant.

      Payment for Exercise of Options. Payment for the exercise of options under the 2003 Plan may be made by one or any combination of the following forms of payment (a) by cash or check payable to the order of NaviSite; (b) except as otherwise explicitly provided in the applicable option agreement, by delivery of an irrevocable and unconditional undertaking by a creditworthy broker to deliver promptly to NaviSite sufficient funds to pay the exercise price or any required tax withholding, or delivery by the Participant to NaviSite of a copy of irrevocable and unconditional instructions to a creditworthy broker to deliver promptly to NaviSite cash or a check sufficient to pay the exercise price and any required tax withholding; (c) when the Common Stock is registered under the Exchange Act, by delivery of shares of Common Stock owned by the Participant valued at fair market value (as determined by or in a manner approved by the Board) provided that such method of payment is then permitted by law and such Common Stock, if acquired directly from NaviSite, was owned by the Participant for at least six months; or (d) to the extent permitted by the Board, (x) by delivery of a promissory note of the Participant to NaviSite (on terms determined by the Board) or (y) payment of such other lawful consideration as the Board may determine.

      Transferability. Except as otherwise provided in the applicable option agreement, options are not transferable except by will or by the laws of descent and distribution.

      Restricted Stock. The Board may grant Awards entitling recipients to acquire shares of Common Stock, subject to the right of NaviSite to repurchase all or part of such shares at their issue price or other stated or formula price from the Participant in the event that conditions specified by the Board in the applicable Award are not satisfied prior to the end of the applicable restriction period or periods established by the Board for such Award.

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      Acquisition of NaviSite. Upon the occurrence of a Reorganization Event (as defined below) or the execution by NaviSite of any agreement with respect to any Reorganization event, the Board shall provide that all outstanding options outstanding under the 2003 Plan shall be assumed, or equivalent options shall be substituted, by the acquiring or succeeding corporation (or an affiliate thereof). If the acquiring or succeeding corporation (or an affiliate thereof) does not agree to assume, or substitute for, such options, then all then unexercised options will become exercisable in full as of a time specified by the Board prior to the Reorganization Event and will terminate immediately prior to the consummation of such Reorganization Event; provided, however, that in the event of a Reorganization Event under the terms of which holders of Common Stock will receive a cash payment for each share of Common Stock surrendered pursuant to such Reorganization Event (the “Acquisition Price”), then the Board may instead provide that all outstanding options outstanding under the 2003 Plan shall terminate upon consummation of such Reorganization Event and that each optionholder shall receive, in exchange therefor, a cash payment equal to the amount (if any) by which (A) the Acquisition Price multiplied by the number of shares of Common Stock subject to such outstanding options (whether or not then exercisable), exceeds (B) the aggregate exercise price of such options.

      Upon the occurrence of a Reorganization Event, the repurchase and other rights of NaviSite under each outstanding restricted stock award shall inure to the benefit of NaviSite’s successor and shall apply to the cash, securities or other property which the Common Stock was converted into or exchanged for pursuant to such Reorganization Event in the same manner and to the same extent as they applied to the Common Stock subject to such restricted stock award. “Reorganization Event” is defined in the 2003 Plan as follows: (a) any merger or consolidation of NaviSite with or into another entity as a result of which all of the Common Stock of NaviSite is converted into or exchanged for the right to receive cash, securities or other property or (b) any exchange of all of the Common Stock of NaviSite for cash, securities or other property pursuant to a share exchange transaction.

      Effect of Termination, Disability or Death. The Board determines the effect on an Award of the disability, death, retirement, authorized leave of absence or other change in the employment or other status of a Participant and the extent to which, and the period during which, the Participant, or the Participant’s legal representative, conservator, guardian or designated beneficiary, may exercise rights under the Award.

      Amendment of Award. The Board of Directors may amend, modify or terminate any outstanding Award, including but not limited to, by substituting therefor another Award of the same or a different type, changing the date of exercise or realization, and converting an ISO (as defined below) to a non-qualified stock option, provided that the Participant’s consent to such action shall be required unless the Board of Directors determines that the action, taking into account any related action, would not materially and adversely affect the Participant.

      Termination and Amendment of Plan. The Board may amend, suspend or terminate the 2003 Plan or any portion thereof at any time. Unless terminated sooner, no Awards may be granted under the 2003 Plan after July 9, 2013, but Awards previously granted may extend beyond that date.

 
United States Federal Income Tax Consequences

      THE FOLLOWING DISCUSSION OF UNITED STATES FEDERAL INCOME TAX CONSEQUENCES OF THE ISSUANCE AND EXERCISE OF OPTIONS GRANTED UNDER THE 2003 PLAN IS BASED UPON THE PROVISIONS OF THE INTERNAL REVENUE CODE AS IN EFFECT ON THE DATE OF THIS INFORMATION STATEMENT, CURRENT REGULATIONS, AND EXISTING ADMINISTRATIVE RULINGS OF THE INTERNAL REVENUE SERVICE. THIS DISCUSSION IS NOT INTENDED TO BE A COMPLETE DISCUSSION OF ALL OF THE UNITED STATES FEDERAL INCOME TAX CONSEQUENCES OF THE 2003 PLAN OR OF THE REQUIREMENTS THAT MUST BE MET IN ORDER TO QUALIFY FOR THE DESCRIBED TAX TREATMENT.

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      Incentive Stock Options (“ISOs”). The following general rules are applicable under current United States federal income tax law to ISOs granted under the 2003 Plan:

  1. In general, an optionee will not recognize any taxable income upon the grant of an ISO or upon the issuance of shares to him or her upon the exercise of an ISO, and NaviSite will not be entitled to a federal income tax deduction upon either the grant or the exercise of an ISO.
 
  2. If shares acquired upon exercise of an ISO are not disposed of within (i) two years from the date the ISO was granted or (ii) one year from the date the shares are issued to the optionee pursuant to the exercise of the ISO (the “Holding Periods”), the difference between the amount realized on any subsequent disposition of the shares and the exercise price generally will be treated as capital gain or loss to the optionee.
 
  3. If shares acquired upon exercise of an ISO are disposed of and the optionee does not satisfy the Holding Periods (a “Disqualifying Disposition”), then in most cases the lesser of (i) any excess of the fair market value of the shares at the time of exercise of the ISO over the exercise price or (ii) the actual gain on disposition, will be treated as compensation to the optionee and will be taxed as ordinary income in the year of such disposition.
 
  4. The difference between the amount realized by an optionee as the result of a Disqualifying Disposition and the sum of (i) the exercise price and (ii) the amount of ordinary income recognized under the above rules generally will be treated as capital gain or loss to the optionee.
 
  5. In any year that an optionee recognizes ordinary income on a Disqualifying Disposition of shares acquired upon exercise of an ISO, NaviSite generally will be entitled to a corresponding federal income tax deduction.
 
  6. An optionee may be entitled to exercise an ISO by delivering shares of NaviSite Common Stock to NaviSite in payment of the exercise price, if the optionee’s ISO agreement so provides. If an optionee exercises an ISO in such fashion, special rules will apply.
 
  7. In addition to the tax consequences described above, the exercise of an ISO may result in an “alternative minimum tax” to the optionee. In general, the amount by which the fair market value of the shares received upon exercise of the ISO exceeds the exercise price is included in the optionee’s alternative minimum taxable income. A taxpayer is required to pay the greater of his regular tax liability or the alternative minimum tax. A taxpayer who pays alternative minimum tax attributable to the exercise of an ISO may be entitled to a tax credit against his or her regular tax liability in later years.
 
  8. Capital gain or loss recognized by an optionee on a disposition of shares will be long-term capital gain or loss if the optionee’s holding period for the shares exceeds one year.
 
  9. Special rules apply if the shares acquired upon the exercise of an ISO are subject to vesting, or are subject to certain reporting requirements and restrictions on resale under federal securities laws applicable to directors, certain officers or 10% stockholders.

      Non-Qualified Options. The following general rules are applicable under current United States federal income tax law to Non-Qualified Options granted under the 2003 Plan:

  1. In general, an optionee will not recognize any taxable income upon the grant of a Non-Qualified Option, and NaviSite will not be entitled to a federal income tax deduction upon such grant.
 
  2. An optionee generally will recognize ordinary income at the time of exercise of the Non-Qualified Option in an amount equal to the excess, if any, of the fair market value of the shares on the date of exercise over the exercise price. NaviSite may be required to withhold tax on this amount.
 
  3. When an optionee sells the shares acquired upon the exercise of a Non-Qualified Option, he or she generally will recognize capital gain or loss in an amount equal to the difference between the amount realized upon the sale of the shares and his or her basis in the shares (generally, the

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  exercise price plus the amount taxed to the optionee as ordinary income). If the optionee’s holding period for the shares exceeds one year, such gain or loss will be a long-term capital gain or loss.

  4. When an optionee recognizes ordinary income attributable to a Non-Qualified Option, NaviSite generally should be entitled to a corresponding federal income tax deduction.
 
  5. An optionee may be entitled to exercise a Non-Qualified Option by delivering shares of NaviSite Common Stock to NaviSite in payment of the exercise price, if the optionee’s option agreement so provides. If an optionee exercises a Non-Qualified Option in such fashion, special rules will apply.
 
  6. Special rules apply if the shares acquired upon the exercise of a Non-Qualified Option are subject to vesting, or are subject to certain reporting requirements and restrictions on resale under federal securities laws applicable to directors, certain officers or 10% stockholders.

      Restricted Stock Awards. The following general rules are applicable under current United States federal income tax law to Awards comprised of restricted Common Stock under the 2003 Plan:

      Persons receiving restricted Common Stock under the under the 2003 Plan pursuant to Awards generally will not recognize taxable income upon the grant of the Award, unless the Participant makes an election under Section 83(b) of the Code (an “83(b) Election”). If the Participant makes an 83(b Election within 30 days of the date of grant, the Participant will recognize ordinary income, for the year the Award is granted, in an amount equal to the difference between the fair market value of the shares received (determined on the date of the Award) over the purchase price. If an 83(b) Election is not made, then the Participant will recognize ordinary income, at the time that the forfeiture provisions or restrictions on transfer lapse, in an amount equal to the difference between the fair market value of the Common Stock at the time of such lapse and the original purchase price paid for the Common Stock. The Participant will have a tax basis in the Common Stock acquired equal to the sum of the price paid and the amount of ordinary income recognized.

      Upon the disposition of the Common Stock acquired pursuant to a restricted stock Award, the Participant will recognize capital gain or loss equal to the difference between the sale price of the Common Stock and the Participant’s basis in the Common Stock. The capital gain or loss will be a long-term capital gain or loss if the shares are held for more than one year.

 
Equity Compensation Plan Information as of July 31, 2003

      The following table sets forth certain information regarding NaviSite’s equity compensation plans as of July 31, 2003.

                         
(a) (b) (c)



Number of Number of Securities
Securities to be Weighted-Average Available for Future
Issued Upon Exercise Price of Issuance Under
Exercise of Outstanding Equity Compensation
Outstanding Options, Plans (Excluding
Options, Warrants Warrants and Securities Reflected
Plan Category and Rights Rights in Column (a))




Equity compensation plans approved by security holders
    273,506     $ 67.93       683,464  
Equity compensation plans not approved by security holders(1)
    2,272,000     $ 2.55       328,000  
     
     
     
 
Total
    2,545,506     $ 9.57       1,011,464  
     
     
     
 


(1)  Consists of options to purchase 2,272,000 shares of Common Stock granted under the 2003 Plan. The 2003 Plan was originally approved, subject to stockholder approval, by the Board of Directors on July 10, 2003, and amended and restated by the Board of Directors on November 11, 2003. The

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2003 Plan was approved by NaviSite’s stockholders on December 9, 2003 at the Annual Meeting of Stockholders.

      On May 6, 2004, Atlantic Investors delivered to the Company an executed written consent of stockholders approving the Stock Plan Amendment. This Information Statement is being sent to all stockholders of the Company as notice that such action has been taken. The Company is not asking that you vote to approve the Stock Plan Amendment. Under federal law governing the taking of stockholder action by written consent, stockholder approval of the Stock Plan Amendment will be deemed effective 20 days after the mailing of this Information Statement to stockholders of the Company.

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

      The following table sets forth certain information as of June 17, 2004 (unless otherwise indicated), with respect to the beneficial ownership of Common Stock by the following:

  •  each person known by the Company to beneficially own more than 5% of the outstanding shares of Common Stock;
 
  •  each of the Company’s directors;
 
  •  each of the Named Executive Officers (as defined below under the heading “Executive Compensation”); and
 
  •  all of the current executive officers and directors as a group.

      For purposes of the following table, beneficial ownership is determined in accordance with the rules promulgated by the Securities and Exchange Commission and the information is not necessarily indicative of beneficial ownership for any other purpose. Except as otherwise noted in the footnotes to the respective tables, the Company believes that each person or entity named in the tables has sole voting and investment power with respect to all shares of Common Stock shown as beneficially owned by them (or shares such power with his or her spouse). Under such rules, shares of Common Stock issuable under options that are currently exercisable or exercisable within 60 days after June 17, 2004 (“Presently Exercisable Options”) are deemed outstanding and are included in the number of shares beneficially owned by a person named in the table and are used to compute the percentage ownership of that person. These shares are not, however, deemed outstanding for computing the percentage ownership of any other person or entity. Unless otherwise indicated, the address of each person listed in the table is c/o NaviSite, Inc., 400 Minuteman Road, Andover, Massachusetts 01810. The percentage ownership of Common Stock of each person or entity named in the following table is based on 27,918,049 shares of Common Stock outstanding as of June 17, 2004 plus any shares subject to Presently Exercisable Options held by such person.

                   
NaviSite Common Stock

Number of Percentage of
Shares Common
Beneficially Stock
Name and Address of Beneficial Owner Owned Outstanding



5% Stockholders
               
Atlantic Investors, LLC(1)
    17,121,652       61.3 %
 
20 East 66th Street
               
 
New York, NY 10021
               
 
Hewlett-Packard Financial Services Company
    4,416,592       15.8 %
 
420 Mountain Ave.
               
 
Murray Hill, NJ 07974
               
 
Surebridge, Inc. 
    3,000,000       10.7 %
 
c/o Spectrum Equity Investors, L.P.
               
 
One International Place, 29th Floor
               
 
Boston, MA 02210
               

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NaviSite Common Stock

Number of Percentage of
Shares Common
Beneficially Stock
Name and Address of Beneficial Owner Owned Outstanding



Directors and Named Executive Officers
               
Andrew Ruhan(2)
          *  
Arthur P. Becker
    415,150 (3)     1.5 %
Gabriel Ruhan
    202,083 (4)     *  
Larry Schwartz
    28,888 (4)     *  
James Dennedy
    31,666 (4)     *  
Thomas R. Evans
    13,889 (4)     *  
Patricia Gilligan(5)
          *  
Kevin H. Lo(6)
          *  
All current executive officers and directors as a group (8 persons)
    728,342 (7)     2.6 %


* Less than 1%.
 
(1)  Based on information provided by Atlantic Investors in a Form 4 dated April 29, 2004 filed with the Securities and Exchange Commission on May 3, 2004. Excludes 170,898 shares subject to an option granted to Mr. Denis Martin.
 
(2)  Excludes 17,121,652 shares of Common Stock owned by Atlantic Investors and 426,134 shares of Common Stock owned by Global Unicorn Worldwide Holdings S.A.R.L., a wholly owned subsidiary of Unicorn Worldwide Holdings Limited, with respect to all of which Mr. A. Ruhan disclaims beneficial ownership. Mr. A. Ruhan holds a 10% equity interest in Unicorn Worldwide Holdings Limited, a managing member of Atlantic Investors.
 
(3)  Consists of 213,067 shares of Common Stock owned by Madison Technology LLC and 202,083 shares of Common Stock issuable upon the exercise of Presently Exercisable Options. Excludes 17,121,652 shares of Common Stock owned by Atlantic Investors with respect to which Mr. Becker disclaims beneficial ownership. Mr. Becker is the managing member of Madison Technology LLC, a managing member of Atlantic Investors.
 
(4)  Consists of shares of Common Stock issuable upon the exercise of Presently Exercisable Options.
 
(5)  Served as the Company’s Chief Executive Officer until February 2003 and her relationship with the Company terminated in March 2003.
 
(6)  Served as the Company’s Chief Financial Officer and Vice President of Finance and Strategy until April 2003.
 
(7)  Consists of 213,067 shares of Common Stock owned by Madison Technology LLC and 515,275 shares of Common Stock issuable upon the exercise of Presently Exercisable Options.

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ADDITIONAL INFORMATION ABOUT NAVISITE

Director Compensation

      In November 2003, after completing a review of director compensation for comparable companies, the Board of Directors agreed (i) to grant to future independent directors upon initial election to the Board options to purchase 50,000 shares of NaviSite Common Stock and (ii) that any independent director be paid $7,500 per year, payable in quarterly installments. Additionally, upon re-election to the Board of Directors subsequent to the 2003 Annual Meeting of Stockholders, independent directors of the Board of Directors will be granted an annual option to purchase 15,000 shares of NaviSite Common Stock. The initial option grant of 50,000 shares shall vest monthly over three years (1/36th of the number of shares vest monthly). The subsequent annual option grant of 15,000 shares shall vest monthly over 12 months. The Chairperson of each of the Audit Committee and the Compensation Committee also will receive, upon re-election to the Board of Directors at each annual meeting of stockholders, an option to purchase 10,000 shares of NaviSite Common Stock. This option shall vest monthly over a period of 12 months.

      During the 2003 fiscal year, directors did not receive any option grants. Messrs. Dennedy and Schwartz each received $1,500 during fiscal year 2003 for service on the Board of Directors and $6,000 each paid in October 2003 for participating on a special committee of the Board of Directors during and subsequent to fiscal year 2003.

      On October 3, 2003, Mr. Evans was elected to the Board of Directors of the Company. At such time, the Company did not have an existing stock option plan pursuant to which Mr. Evans was eligible to participate and receive an initial option grant. On December 9, 2003, the stockholders of the Company approved the 2003 Plan. On such date, Mr. Evans was granted an option to purchase 50,000 shares of Common Stock under such plan. A Special Committee of the Board of Directors determined that the exercise price of such option be set at $3.53 per share, equal to the closing price of the Company’s Common Stock on October 3, 2003. The option was vested and exercisable as to 2/36th of the number of shares subject to the option on the date of grant. The option vests and becomes exercisable as to 1/36th of the number of shares subject to the option on the third day of each month commencing January 3, 2004 until fully vested on October 3, 2006.

      On April 3, 2003, Mr. Schwartz was elected to the Board of Directors of the Company. On July 10, 2003, the Company granted stock options to substantially all of its executive officers and employees. At such time, the Company did not have an existing stock option plan pursuant to which Mr. Schwartz was eligible to participate and receive an initial option grant. On December 9, 2003, the stockholders of the Company approved the 2003 Plan. On such date, Mr. Schwartz was granted an option to purchase 50,000 shares of Common Stock under such plan. A Special Committee of the Board of Directors determined that the exercise price of such option be set at $2.55 per share, equal to the closing price of the Company’s Common Stock on July 10, 2003. The option was vested and exercisable as to 8/36th of the number of shares subject to the option on the date of grant. The option vests and becomes exercisable as to 1/36th of the number of shares subject to the option on the third day of each month commencing January 3, 2004 until fully vested on April 3, 2006.

      On January 27, 2003, Mr. Dennedy was elected to the Board of Directors of the Company. On July 10, 2003, the Company granted stock options to substantially all of its executive officers and employees. At such time, the Company did not have an existing stock option plan pursuant to which Mr. Dennedy was eligible to participate and receive an initial option grant. On December 9, 2003, the stockholders of the Company approved the 2003 Plan. On such date, Mr. Dennedy was granted an option to purchase 50,000 shares of Common Stock under such plan. A Special Committee of the Board of Directors determined that the exercise price of such option be set at $2.55 per share, equal to the closing price of the Company’s Common Stock on July 10, 2003. The option was vested and exercisable as to 10/36th of the number of shares subject to the option on the date of grant. The option vests and becomes

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exercisable as to 1/36th of the number of shares subject to the option on the 27th day of each month commencing December 27, 2003 until fully vested on January 27, 2006.

      In connection with his chairmanship of the Compensation Committee of the Board of Directors, on December 9, 2003, Mr. Schwartz was granted an option to purchase 10,000 shares of Common Stock. The option vests and becomes exercisable as to 1/12th of the number of shares subject to the option on each monthly anniversary date of the date of grant until fully vested on the first anniversary of the date of grant.

      In connection with his chairmanship of the Audit Committee of the Board of Directors, on December 9, 2003, Mr. Dennedy was granted an option to purchase 10,000 shares of Common Stock. The option vests and becomes exercisable as to 1/12th of the number of shares subject to the option on each monthly anniversary date of the date of grant until fully vested on the first anniversary of the date of grant.

      Apart from the arrangements discussed above, NaviSite does not pay any cash compensation to members of its Board of Directors for their services as members of the Board of Directors, although directors are reimbursed for their reasonable travel expenses incurred in connection with attending Board of Directors and committee meetings. Directors who are also NaviSite officers or employees are eligible to participate in the 2003 Plan. Following approval by NaviSite’s stockholders in December 2003 of the 2003 Plan, no additional option grants shall be made under the 1998 Equity Incentive Plan, the 1999 Stock Option Plan for Non-Employee Directors or the 2000 Stock Option Plan. However, all then-outstanding options under such plans shall remain in effect and the option grants to the independent directors, as described above, will be made under the 2003 Plan.

      NaviSite and each member of the Board of Directors have entered into an indemnification agreement pursuant to which the directors will be indemnified by NaviSite, subject to certain limitations, for any liabilities incurred by the directors in connection with their role as directors of NaviSite.

Executive Compensation

 
Summary Compensation Table

      The following table sets forth certain summary information with respect to the compensation paid during the fiscal years ended July 31, 2003, 2002 and 2001 earned by each of (i) all individuals who served as the Chief Executive Officer during the fiscal year ended July 2003, (ii) one other executive officer who was serving as an executive officer on July 31, 2003 whose total annual salary and bonuses for fiscal year 2003 exceeded $100,000 and (iii) one former executive officer who would have been among the most highly compensated executive officers during fiscal year 2003 had he remained as an executive officer as of July 31, 2003 (collectively, the “Named Executive Officers”). In the table below, columns required by the regulations of the SEC have been omitted where no information was required to be disclosed under those columns.

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SUMMARY COMPENSATION TABLE
                                           
Long-Term
Compensation

Awards

Annual Compensation Securities

Underlying All Other
Name and Principal Position July 31, Salary Bonus Options Compensation






Arthur P. Becker(1)
    2003     $ 121,635             40,000        
 
Chief Executive Officer and President
                                       
Gabriel Ruhan(2)
    2003     $ 205,769             40,000        
 
Chief Operating Officer
                                       
Patricia Gilligan
    2003     $ 176,634                 $ 276,756 (3)
 
Former Chief Executive Officer
    2002     $ 262,724     $ 122,025 (4)     33,333     $ 2,921 (5)
        2001     $ 215,909     $ 180,713 (6)     19,833     $ 3,501 (5)
Kevin H. Lo
    2003     $ 147,692                 $ 210,615 (7)
 
Former Chief Financial Officer
    2002     $ 175,628     $ 117,000 (8)     33,333        
 
and Former Senior Vice President
    2001     $ 100,660     $ 8,274       12,333        
 
of Finance and Strategy
                                       


(1)  Mr. Becker became NaviSite’s Chief Executive Officer and President in February 2003.
 
(2)  Mr. Ruhan served as NaviSite’s Executive Vice President for Business Development from October 2002 until April 2003, when he became NaviSite’s Chief Operating Officer.
 
(3)  Includes $275,000 of severance and $1,756 to cover certain health benefits. Ms. Gilligan’s relationship with NaviSite ended in March 2003.
 
(4)  Includes $50,000 retention bonus paid on March 15, 2002 and $72,025 management incentive bonus paid on August 19, 2002.
 
(5)  Represents the amount of matching contributions made by NaviSite under CMGI’s 401(k) Plan.
 
(6)  Includes $125,000 retention bonus paid on July 31, 2001.
 
(7)  Consists of a severance payment of $200,000, plus $1,000 to cover certain health benefits and a vacation payout of $9,615. Mr. Lo’s employment with NaviSite ended in April 2003.
 
(8)  Consists of $50,000 retention bonus, $25,000 of which was paid on December 14, 2001 and $25,000 of which was paid on March 15, 2002, and $67,000 management incentive bonus paid on August 19, 2002.
 
Option Grants During the Fiscal Year Ended July 31, 2003

      The following table sets forth information regarding options to purchase NaviSite Common Stock granted to the Named Executive Officers during the fiscal year ended July 31, 2003. The exercise price per share of each option is equal to the fair market value of NaviSite Common Stock on the date of grant, as determined pursuant to the 1998 Equity Incentive Plan. Potential realizable values set forth in the table are net of the exercise price, but before taxes associated with the exercise, and are based on the assumption that NaviSite Common Stock appreciates at the annual rate shown from the date of the grant until the expiration of the ten-year option term. These numbers are calculated based on rules of the SEC and do not represent NaviSite’s estimate or projection of future stock prices. The actual amount a Named Executive Officer may realize, if any, will depend upon the future performance of NaviSite Common Stock and the optionholder’s continued employment with NaviSite through the vesting period. Accordingly, the potential realizable values reflected in the table may not be achieved. NaviSite has never granted any stock appreciation rights.

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STOCK OPTION GRANTS IN THE FISCAL YEAR ENDED JULY 31, 2003
                                                 
Individual Grants Potential Realizable

Value at Assumed
Number of Percent of Annual Rates of Stock
Securities Total Options Price Appreciation for
Underlying Granted to Exercise Option Term
Options Employees in Price Expiration
Name Granted Fiscal Year (Per Share) Date 5% 10%







Arthur P. Becker(1)
    40,000       31.21 %(2)   $ 2.55       7/9/2013     $ 64,147     $ 162,562  
Gabriel Ruhan(1)
    40,000       31.21 %(2)   $ 2.55       7/9/2013     $ 64,147     $ 162,562  
Patricia Gilligan
                                   
Kevin H. Lo
                                   


(1)  On July 10, 2003, each was granted this option under the 1998 Equity Incentive Plan. The options are exercisable with respect to 50% of the underlying shares as of the grant date, July 10, 2003, and thereafter, exercisable in equal monthly installments of 1/24th of the number of shares and shall be exercisable in full on the first anniversary of the grant date. With respect to each option grant, 100% of the option vests and becomes exercisable in the event of a change in control and termination of employment within twelve months from such change in control.
 
(2)  Based on option grants under all of NaviSite’s equity incentive plans other than the grants made pursuant to the 2003 Plan, which were subject to stockholder approval at July 31, 2003.
 
Options Exercised During Fiscal Year Ended July 31, 2003

      The following table sets forth information concerning options to purchase NaviSite Common Stock exercised by the Named Executive Officers during the fiscal year ended July 31, 2003, and the number and value of unexercised options to purchase NaviSite Common Stock held by the Named Executive Officers as of July 31, 2003.

 
AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND
FISCAL YEAR-END OPTION VALUES
                                 
Number of Securities Value of Unexercised
Underlying Unexercised In-the-Money Options
Options at July 31, 2003 at July 31, 2003(1)


Name Exercisable Unexercisable Exercisable Unexercisable





Arthur P. Becker
    20,000       20,000     $ 8,000     $ 8,000  
Gabriel Ruhan
    20,000       20,000     $ 8,000     $ 8,000  
Patricia Gilligan
                       
Kevin H. Lo
                       


(1)  The value of the unexercised in-the-money NaviSite options is calculated by multiplying the number of shares of NaviSite Common Stock underlying the options by the difference between $2.95, which was the closing price per share of NaviSite Common Stock on the Nasdaq SmallCap Market on July 31, 2003 and the applicable per share exercise price of the option.

Compensation Committee Interlocks and Insider Participation

      The Compensation Committee currently consists of Messrs. Dennedy, Schwartz and Evans. During fiscal year 2003, Messrs. David Wetherell, Andrew Ruhan and Arthur Becker served as members of the Compensation Committee. Mr. Wetherell is the Chairman of CMGI, with whom NaviSite had a significant relationship until September 2002. Since 2000, Mr. Andrew Ruhan, our Chairman, has served as Chief Executive Officer of ClearBlue and Mr. Becker, our Chief Executive Officer and President and a member of the Board of Directors, has served as Vice Chairman and a director of ClearBlue. CMGI, NaviSite, ClearBlue and certain of ClearBlue’s affiliates engaged in various transactions during fiscal year 2003. ClearBlue was the majority stockholder of NaviSite until August 2003, when it distributed the

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Common Stock it held in NaviSite to its equityholders. As a result of such distribution, Atlantic Investors is now the holder of a majority of our outstanding stock. As of May 6, 2004, Atlantic Investors and its affiliates owned, directly or indirectly, approximately 69.6% of the outstanding capital stock of NaviSite. Mr. Becker is a co-founder of Atlantic Investors. Since 1999, Mr. Becker has been a Managing Member of Madison Technology LLC, an investment fund that is focused on technology and telecommunications companies, which is a managing member of Atlantic Investors.

Compensation Committee Report

      This report discusses the Compensation Committee’s compensation objectives and policies with respect to NaviSite’s executive officers. The report reviews the compensation of senior executive officers as a group for the last fiscal year and, specifically, the compensation of Arthur P. Becker, NaviSite’s Chief Executive Officer.

      Compensation Philosophy. NaviSite’s executive compensation program has three objectives: (i) to align the interests of its executive officers with the interests of NaviSite’s stockholders by basing a significant portion of an executive’s compensation on NaviSite’s performance; (ii) to attract and retain highly talented and productive executives; and (iii) to provide incentives for superior performance by NaviSite’s executives. To achieve these objectives, the Compensation Committee has crafted a program that consists of base salary, short-term incentive compensation in the form of a bonus, and long-term incentive compensation in the form of stock options. These compensation elements are in addition to the general benefit programs that are offered to all of NaviSite’s employees.

      The Compensation Committee reviews NaviSite’s executive compensation program annually. In its review, the Compensation Committee assesses the competitiveness of NaviSite’s executive compensation program and reviews NaviSite’s performance for the previous fiscal year. In future years, the Compensation Committee will gauge the success of the compensation program in achieving its objectives in the previous year and will consider NaviSite’s overall performance objectives. Each element of NaviSite’s executive compensation program is discussed below.

      Benefits. The Compensation Committee believes that NaviSite must offer a competitive benefits program to attract and retain key executives. NaviSite provides the same medical and other benefits to its executive officers that are generally available to its other employees. Senior executives, along with all eligible employees of NaviSite, may also choose to participate in NaviSite’s 401(k) plan.

      Long-Term Incentive Compensation. The Compensation Committee believes that placing a portion of an executive’s total compensation in the form of stock options achieves three objectives: (i) it aligns the interest of NaviSite’s executives directly with those of NaviSite’s stockholders; (ii) it gives executives a significant long-term interest in NaviSite’s success; and (iii) it helps NaviSite retain key executives. In determining the number and terms of options to grant an executive, the Compensation Committee will primarily consider subjectively the executive’s past performance and the degree to which an incentive for long-term performance would benefit NaviSite.

      Compensation of the Chief Executive Officer. The Compensation Committee believes that the compensation of the Chief Executive Officer is consistent with NaviSite’s general policies concerning executive compensation and is appropriate in light of NaviSite’s financial objectives and performance. Awards of intermediate and long-term incentive compensation to the Chief Executive Officer are considered concurrently with awards to other executive officers and follow the same general policies as such other intermediate and long-term incentive awards.

      Mr. Becker has served as a director of NaviSite since September 11, 2002 and became its Chief Executive Officer and President in February 2003. Mr. Becker’s base salary for the portion of the last fiscal year during which he served as Chief Executive Officer was at a rate of $275,000 per year. In July 2003, Mr. Becker also received an option to acquire 40,000 shares of NaviSite Common Stock at an exercise price of $2.55 per share. Mr. Becker’s compensation was designed to align his interests with those of NaviSite’s stockholders by tying the value of the stock option award and his eligibility for periodic cash

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bonuses to the success of his efforts towards building NaviSite’s management team, business and infrastructure and improving the operating and financial performance of NaviSite. The Compensation Committee believes that Mr. Becker’s compensation has been consistent with the Compensation Committee’s compensation philosophy.

      During NaviSite’s last fiscal year, under the leadership of Mr. Becker, NaviSite successfully executed its business plan and stabilized its business. Operationally, during fiscal year 2003, NaviSite experienced a significant transition, including the acquisitions discussed in “Certain Relationships and Related Transactions” and a balance sheet restructuring, to position NaviSite among the leaders in the outsourced hosting and managed application services market. NaviSite also expanded its service offerings and diversified its customer base, while at the same time implemented an operational plan that should bring costs more in line with projected revenue growth.

      Policy on Deductibility of Executive Compensation. Section 162(m) of the Internal Revenue Code of 1986, as amended (the “Code”), generally disallows a federal income tax deduction to public companies for certain compensation over $1,000,000 paid to a company’s chief executive officer and four other most highly compensated executive officers. Qualifying performance-based compensation will not be subject to the deduction limit if certain requirements are met. The Compensation Committee intends to review the potential effects of Section 162(m) periodically and intends to structure NaviSite’s stock option grants and certain other equity-based awards in a manner that is intended to avoid disallowances under Section 162(m) of the Code unless the Compensation Committee believes that such compliance would not be in the best interest of NaviSite or its stockholders.

  COMPENSATION COMMITTEE
 
  Larry Schwartz, Chairman
  James Dennedy
  Thomas R. Evans

Change in Control

      On September 11, 2002, each of CMGI, Inc. (“CMGI”) and Hewlett-Packard Financial Services Company sold and transferred to ClearBlue Technologies, Inc., a privately-held managed service provider based in San Francisco, California (“ClearBlue”), and certain of its subsidiaries, the following equity and debt interests in the Company:

  •  Pursuant to a Note and Stock Purchase Agreement by and between CMGI and ClearBlue, CMGI sold and transferred to ClearBlue approximately 4.7 million shares of Common Stock, representing approximately 76% of the outstanding capital stock of the Company, warrants to purchase approximately 345,000 shares of Common Stock and a convertible note with an aggregate principal amount outstanding of $10 million. The $10 million convertible note was convertible into approximately 2.5 million shares of Common Stock. ClearBlue issued 131,579 shares of ClearBlue common stock to CMGI in the transaction, representing approximately 2% of the issued and outstanding equity of ClearBlue after giving effect to the transactions on such date with CMGI and Hewlett-Packard Financial Services Company.
 
  •  Pursuant to a Note and Stock Purchase Agreement by and between Hewlett-Packard Financial Services Company and ClearBlue, Hewlett-Packard Financial Services Company sold and transferred to ClearBlue approximately 213,000 shares of Common Stock, and convertible notes with an aggregate principal amount outstanding of approximately $55 million. The $55 million convertible notes were convertible into approximately 14.1 million shares of Common Stock. ClearBlue issued 1,447,368 shares of ClearBlue common stock to Hewlett-Packard Financial Services Company in the transaction, representing approximately 22% of the issued and outstanding equity of ClearBlue after giving effect to the transactions on such date with CMGI and Hewlett-Packard Financial Services Company.

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      As a result of the foregoing transactions, ClearBlue became NaviSite’s majority stockholder. In August 2003, ClearBlue transferred to its stockholders, including Atlantic Investors, its majority stockholder, the shares of Common Stock owned by it. On May 6, 2004, Atlantic Investors held 17,292,550 shares, or approximately 69.6%, of the Company’s Common Stock.

Stock Performance Graph

      The following graph compares the cumulative total return to stockholders of NaviSite Common stock for the period from October 22, 1999, the date NaviSite Common Stock was first traded on The Nasdaq National Market, through July 31, 2003, with the cumulative total return over the same period of (i) the Nasdaq Composite Index and (ii) a peer group index of publicly traded companies that provide similar services to those of NaviSite (the “Peer Group Index”). The graph assumes the investment of $100 in NaviSite Common Stock (at the closing price on the date of NaviSite’s initial public offering) and in each of such indices (and the reinvestment of all dividends, if any) on October 22, 1999. The performance shown is not necessarily indicative of future performance.

Comparison of Cumulative Total Return

(Assumes Initial Investment of $100)
October 22, 1999 Through July 31, 2003

(PERFORMANCE GRAPH)

                         

Nasdaq
 Measurement Period Composite Peer Group
 (Fiscal Year Covered) NaviSite, Inc. Index Index(1)

 10/22/99
  $ 100.00     $ 100.00     $ 100.00  
 7/31/00
  $ 243.30     $ 133.70     $ 97.14  
 7/31/01
  $ 4.31     $ 71.76     $ 82.27  
 7/31/02
  $ 0.69     $ 47.43     $ 47.83  
 7/31/03
  $ 1.13     $ 62.13     $ 49.56  


(1)  The Peer Group Index is a modified-capitalization weighted index of stocks selected by NaviSite that represents the following publicly traded companies: International Business Machines Corporation, Electronic Data Systems Corporation, Computer Sciences Corporation, Level 3 Communications, Inc., Qwest Communications International Inc., divine, inc., AT&T Corp., Digex, Incorporated, Akamai Technologies, Inc., Corio, Inc. and SBC Communications Inc.

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Table of Contents

      Notwithstanding anything to the contrary set forth in any of NaviSite’s filings under the Securities Act or the Exchange Act that might incorporate other filings with the SEC, including this Information Statement, in whole or in part, the Compensation Committee Report and the Stock Performance Graph shall not be deemed incorporated by reference into any such filings.

Employment Agreements and Severance and Change of Control Arrangements

      NaviSite entered into an employment agreement with Arthur P. Becker as of February 21, 2003, pursuant to which he would be employed as NaviSite’s Chief Executive Officer and President. His agreement is for a continuous term, but subject to the provisions described below, may be terminated by either party at any time. Pursuant to this agreement, Mr. Becker is entitled to receive:

  •  a base salary, currently $275,000 per year, which is reviewed by our Board of Directors annually (but no more frequently than annually);
 
  •  an annual bonus upon NaviSite’s achievement of various financial and/or other goals established by the Board; and
 
  •  fringe benefits, including stock options and health insurance and other benefits available to our employees.

      If Mr. Becker’s employment is terminated (i) by reason of death or disability, (ii) by NaviSite with cause or (iii) due to his voluntarily resignation, then he will receive no additional salary or benefits other than what has accrued through the date of termination.

      If Mr. Becker’s employment is terminated without cause and he signs a general release of known and unknown claims in a form satisfactory to NaviSite, Mr. Becker will receive severance payments at his final base salary rate, less applicable withholding, until the earlier of (i) six months after the date of his termination without cause, or (ii) the date on which he first commences other employment.

      In connection with the termination of their employment with us, each of Ms. Gilligan and Mr. Lo entered into a Severance Agreement and General Release which provided for the following in exchange for the general release of all claims against NaviSite and related parties:

  •  Ms. Gilligan received a severance payment of $275,000, plus $1,756 to cover certain health benefits.
 
  •  Mr. Lo received a severance payment of $200,000, plus $1,000 to cover certain health benefits and a vacation payout of $9,615.

Financial and Other Information

      Certain financial and other information regarding NaviSite and Surebridge is included in the financial pages to this Information Statement.

  By Order of the Board of Directors,
 
  -s- Kenneth Drake
 
  KENNETH DRAKE
  Secretary
July [     ], 2004

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INDEX TO FINANCIAL AND OTHER INFORMATION

           
Page

Audited NaviSite, Inc. Financial Statements:
       
 
Report of Independent Registered Public Accounting Firm
    F-2  
 
Consolidated Balance Sheets as of July 31, 2003 and 2002
    F-3  
 
Consolidated Statements of Operations for the years ended July 31, 2003, 2002 and 2001
    F-4  
 
Consolidated Statements of Changes in Stockholders’ Equity (Deficit) for the years ended July 31, 2003, 2002 and 2001
    F-5  
 
Consolidated Statements of Cash Flows for the years ended July 31, 2003, 2002, and 2001
    F-6  
 
Notes to Consolidated Financial Statements
    F-7  
 
Report of Independent Registered Public Accounting Firm on Financial Statement Schedule
    F-39  
 
Financial Statement Schedule II — Valuation and Qualifying Accounts
    F-40  
Unaudited NaviSite, Inc. Interim Financial Statements:
       
 
Consolidated Balance Sheets as of April 30, 2004 and July 31, 2003
    F-41  
 
Consolidated Statements of Operations for the three and nine months ended April 30, 2004 and 2003
    F-42  
 
Consolidated Statements of Cash Flows for the nine months ended April 30, 2004 and 2003
    F-43  
 
Notes to Consolidated Financial Statements
    F-44  
Surebridge, Inc. Consolidated Financial Statements for the three months ended March 31, 2004 (unaudited) and for the year ended December 31, 2003:
       
 
Independent Auditors’ Report
    F-67  
 
Consolidated Balance Sheets as of March 31, 2004 (unaudited) and December 31, 2003
    F-68  
 
Consolidated Statements of Operations for the three months ended March 31, 2004 and 2003 (unaudited) and for the year ended December 31, 2003
    F-69  
 
Consolidated Statements of Stockholders’ Deficit for the three months ended March 31, 2004 (unaudited) and for the year ended December 31, 2003
    F-70  
 
Consolidated Statements of Cash Flows for the three months ended March 31, 2004 and 2003 (unaudited) and for the year ended December 31, 2003
    F-71  
 
Notes to the Consolidated Financial Statements
    F-72  
Surebridge, Inc. Consolidated Financial Statements for the years ended December 31, 2002 and 2001:
       
 
Report of Independent Auditors
    F-92  
 
Consolidated Balance Sheets as of December 31, 2002 and 2001
    F-93  
 
Consolidated Statements of Operations for the years ended December 31, 2002 and 2001
    F-94  
 
Consolidated Statements of Stockholders’ Deficit for the years ended December 31, 2002 and 2001
    F-95  
 
Consolidated Statements of Cash Flows for the years ended December 31, 2002 and 2001
    F-96  
 
Notes to the Consolidated Financial Statements
    F-97  
Unaudited Pro Forma Condensed Combined Financial Information
    F-117  
Management’s Discussion and Analysis of Financial Condition and Results of Operations
    F-125  

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Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders
NaviSite, Inc. and Subsidiaries:

      We have audited the accompanying consolidated balance sheets of NaviSite, Inc. and Subsidiaries as of July 31, 2003 and 2002, and the related consolidated statements of operations, changes in stockholders’ equity (deficit), and cash flows for each of the years in the three-year period ended July 31, 2003. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

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

      In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of NaviSite, Inc. and Subsidiaries as of July 31, 2003 and 2002, and the results of their operations and their cash flows for each of the years in the three-year period ended July 31, 2003, in conformity with accounting principles generally accepted in the United States of America.

      The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 3 to the financial statements, the Company has incurred recurring losses from operations since inception and has an accumulated deficit. These factors, among others as discussed in Note 3 to the financial statements, raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 3. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

/s/ KPMG LLP

Boston, Massachusetts

October 21, 2003

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NAVISITE, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

                     
July 31,

2003 2002


(In thousands,
except par value)
ASSETS
Current Assets:
               
 
Cash and cash equivalents
  $ 3,862     $ 21,842  
 
Accounts receivable, less allowance for doubtful accounts of $2,030 and $617 at July 31, 2003 and 2002, respectively
    14,741       3,553  
 
Due from related parties
          3,724  
 
Prepaid expenses and other current assets
    4,011       3,292  
 
Assets held for sale
          1,022  
     
     
 
   
Total current assets
    22,614       33,433  
Property and equipment, net
    22,165       12,412  
Customer lists, net of $3,724 of accumulated amortization
    12,052        
Goodwill
    3,206        
Other assets
    6,280       3,839  
Restricted cash
    3,054       3,850  
     
     
 
   
Total assets
  $ 69,371     $ 53,534  
     
     
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities:
               
 
Accounts receivable financing line
  $ 6,358     $  
 
Current notes payable
    1,211        
 
Capital lease obligations, current portion
    3,268       2,123  
 
Current note payable to related party
    3,000        
 
Due to CMGI
          3,241  
 
Accounts payable
    4,371       1,803  
 
Accrued expenses
    17,580       7,932  
 
Deferred revenue
    2,993       1,619  
 
Customer deposits
    134       199  
     
     
 
   
Total current liabilities
    38,915       16,917  
Capital lease obligations, less current portion
    1,907       378  
Accrued lease abandonment costs, less current portion
    3,476        
Note to the AppliedTheory estate
    6,000        
Other long-term liabilities
    2,194        
Convertible notes payable to HPFS, net
          23,440  
Convertible notes payable to CMGI, net
          4,255  
     
     
 
   
Total liabilities
    52,492       44,990  
Commitments and contingencies (note 10)
               
Stockholders’ equity (deficit):
               
Preferred Stock, $0.01 par value. Authorized 5,000 shares; no shares issued or outstanding at July 31, 2003 and 2002
           
Common Stock, $0.01 par value. Authorized 395,000 shares; issued and outstanding 23,412 and 6,248 at July 31, 2003 and 2002
    235       62  
Accumulated other comprehensive income (loss)
    (16 )      
Additional paid-in capital
    432,399       345,820  
Accumulated deficit
    (415,739 )     (337,338 )
     
     
 
   
Total stockholders’ equity
    16,879       8,544  
     
     
 
   
Total liabilities and stockholders’ equity
  $ 69,371     $ 53,534  
     
     
 

See accompanying notes to consolidated financial statements.

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NAVISITE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

                             
Years Ended July 31,

2003 2002 2001



(In thousands, except per share data)
Revenue:
                       
Revenue
  $ 75,281     $ 40,968     $ 66,358  
Revenue, related parties
    1,310       18,453       36,368  
     
     
     
 
Total revenue
    76,591       59,421       102,726  
     
     
     
 
Cost of revenue
    70,781       67,000       127,155  
Impairment, restructuring and other
          68,317       1,930  
     
     
     
 
Total cost of revenue
    70,781       135,317       129,085  
     
     
     
 
Gross profit (deficit)
    5,810       (75,896 )     (26,359 )
     
     
     
 
Operating expenses:
                       
 
Product development
    950       5,281       14,072  
 
Selling and marketing
    5,960       9,703       32,251  
 
General and administrative
    20,207       19,272       33,011  
 
Impairment, restructuring and other
    8,882       (2,633 )     8,011  
     
     
     
 
   
Total operating expenses
    35,999       31,623       87,345  
     
     
     
 
Loss from operations
    (30,189 )     (107,519 )     (113,704 )
Other income (expense):
                       
 
Interest income
    851       1,060       2,753  
 
Interest expense
    (43,403 )     (14,718 )     (8,042 )
 
Other income (expense), net
    (733 )     (516 )     292  
     
     
     
 
Loss before cumulative effect of change in accounting principle and income tax expense
    (73,474 )     (121,693 )     (118,701 )
Income tax expense
    (153 )            
     
     
     
 
Loss before cumulative effect of change in accounting principle
    (73,627 )     (121,693 )     (118,701 )
Cumulative effect of change in accounting principle
                (4,295 )
     
     
     
 
Net loss
  $ (73,627 )   $ (121,693 )   $ (122,996 )
     
     
     
 
Basic and diluted net loss per common share:
                       
 
Before cumulative effect of change in accounting principle
  $ (6.32 )   $ (22.30 )   $ (30.18 )
 
Cumulative effect of change in accounting principle
                (1.09 )
     
     
     
 
 
Basic and diluted net loss per common share
  $ (6.32 )   $ (22.30 )   $ (31.27 )
     
     
     
 
 
Basic and diluted weighted average number of common shares outstanding
    11,654       5,457       3,933  
     
     
     
 

See accompanying notes to consolidated financial statements.

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NAVISITE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (DEFICIT)

                                                         
Common Stock Cumulative Additional Stockholders’

Deferred Translation Paid-in Accumulated Equity
Shares Amount Compensation Adjustment Capital Deficit (Deficit)







(In thousands)
Balance at July 31, 2000
    3,891     $ 39     $ (762 )   $     $ 190,846     $ (92,649 )   $ 97,474  
Issuance of common stock in connection with employee stock purchase plan and exercise of stock options
    48       0                   982             982  
Issuance of stock warrants in connection with convertible debt
                            12,918             12,918  
Issuance of common stock in connection with the interest on convertible debt
    186       2                   3,607             3,609  
Deferred stock compensation related to acquisition
                (289 )           289              
Amortization of deferred stock compensation
                1,051                         1,051  
Net loss
                                  (122,996 )     (122,996 )
     
     
     
     
     
     
     
 
Balance at July 31, 2001
    4,125     $ 41     $     $     $ 208,642     $ (215,645 )   $ (6,962 )
Issuance of common stock in connection with employee stock purchase plan and exercise of stock options
    35       0                   36             36  
Conversion of CMGI convertible debt and other amounts due to CMGI
    1,624       16                   87,137             87,153  
Issuance of common stock in connection with the interest on convertible debt
    464       5                   2,980             2,985  
Beneficial conversion feature of debt issued to CMGI and HPFS
                            42,561             42,561  
Net settlement of debt to CMGI
                            4,464             4,464  
Net loss
                                  (121,693 )     (121,693 )
     
     
     
     
     
     
     
 
Balance at July 31, 2002
    6,248     $ 62     $     $     $ 345,820     $ (337,338 )   $ 8,544  
Issuance of common stock in connection with employee stock purchase plan and exercise of stock options
    2                         2             2  
Common control merger with CBTM
    568       6                   3,360       (515 )     2,851  
Common control merger with CBT
                                    16,664       (4,259 )     12,405  
Conversion of CBT convertible debt and other amounts due to CBT
    16,363       165                   65,816             65,981  
Issuance of common stock in connection with the acquisition of Avasta
    231       2                   367             369  
Issuance of stock warrants to Silicon Valley Bank
                            370             370  
Net loss
                                  (73,627 )     (73,627 )
Change in foreign currency translation adjustment
                      (16 )                 (16 )
                                                     
 
Comprehensive loss
                                        (73,643 )
     
     
     
     
     
     
     
 
Balance at July 31, 2003
    23,412     $ 235     $     $ (16 )   $ 432,399     $ (415,739 )   $ 16,879  
     
     
     
     
     
     
     
 

See accompanying notes to consolidated financial statements.

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NAVISITE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

                                 
Years Ended July 31,

2003 2002 2001



(In thousands)
Cash flows from operating activities:
                       
 
Net loss
  $ (73,627 )   $ (121,693 )   $ (122,996 )
 
Adjustments to reconcile net loss to net cash used for operating activities:
                       
   
Depreciation and amortization
    14,148       20,649       15,154  
   
Amortization of beneficial conversion feature to interest expense
    37,398       5,163        
   
Interest on debt paid in stock
    2,098       3,695        
   
Impairment of long-lived assets
    1,190       68,317        
   
Impairment of goodwill and intangibles
    1,831       186        
   
Write-down of assets held for sale
          524        
   
(Gain) loss on disposal of assets
    250       1,363       (133 )
   
Gain on sale of Streaming Media assets
          (524 )      
   
Costs associated with abandoned leases
    6,127              
   
Amortization of warrants
    66              
   
Provision for bad debts
    1,583       3,490       11,948  
   
Amortization of deferred compensation
                1,051  
   
Interest on convertible notes payable to CMGI
                3,609  
   
Accretion of debt discount
          1,172       2,691  
   
Changes in operating assets and liabilities, net of impact of acquisitions:
                       
     
Accounts receivable
    (1,371 )     3,600       (6,373 )
     
Due from CMGI and affiliates
    (22 )     (266 )     1,623  
     
Prepaid expenses and other current assets, net
    1,820       178       1,016  
     
Due to CMGI
    (3,241 )     7,218       9,511  
     
Long-term assets
    675       (379 )     (58 )
     
Accounts payable
    (2,614 )     (8,537 )     (3,116 )
     
Customer deposits
    (65 )     (19 )     218  
     
Long-term liabilities
    163              
     
Accrued expenses and deferred revenue
    (958 )     (11,172 )     (2,945 )
     
     
     
 
       
Net cash used for operating activities
    (14,549 )     (27,035 )     (88,800 )
Cash flows from investing activities:
                       
 
Net cash acquired in acquisitions
    3,981              
 
Purchase of property and equipment
    (1,067 )     (4,182 )     (25,515 )
 
Purchase of debt securities
    (1,963 )            
 
Cash used to acquire Interliant assets
    (5,830 )            
 
Loan to related party
    (1,596 )            
 
Proceeds from repayment of loan to related party
    200              
 
Proceeds from the sale of Streaming Media assets
          1,600        
 
Proceeds from the sale of equipment
    475       1,440       13,884  
 
Restricted cash
    3,878       1,201       (5,051 )
 
Other assets
          577       (747 )
     
     
     
 
       
Net cash provided by (used for) investing activities
    (1,922 )     636       (17,429 )
Cash flows from financing activities:
                       
 
Issuance of convertible notes payable to CMGI
                80,000  
 
Issuance of convertible notes payable to CMGI and HPFS
          30,000        
 
Proceeds from exercise of stock options and employee stock purchase plan
          35       982  
 
Repayment of note payable
          (1,874 )      
 
Debt repayment to the AppliedTheory estate
    (6,100 )            
 
Borrowing under note to affiliate
    5,850              
 
Net borrowings under accounts receivable line
    6,359              
 
Payments under note to affiliates
    (2,600 )            
 
Payment of capital lease obligations
    (5,018 )     (1,218 )     (29,646 )
 
Payments of software vendor obligations
          (916 )     (840 )
     
     
     
 
       
Net cash provided by (used for) financing activities
    (1,509 )     26,027       50,496  
Net decrease in cash
    (17,980 )     (372 )     (55,733 )
Cash and cash equivalents, beginning of year
    21,842       22,214       77,947  
     
     
     
 
Cash and cash equivalents, end of year
  $ 3,862     $ 21,842     $ 22,214  
     
     
     
 
Supplemental disclosure of cash flow information:
                       
Cash paid for interest
  $ 704     $ 3,553     $ 1,364  
     
     
     
 

See accompanying notes to consolidated financial statements.

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Table of Contents

NAVISITE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(1)     Description of Business

      NaviSite, Inc. provides outsourced hosting and managed application services for middle-market organizations which include mid-sized companies, divisions of large multi-national companies and government agencies. Substantially all revenues are generated from customers in the United States.

(2)     Summary of Significant Accounting Policies

      (a)     Basis of Presentation

 
      Restatement of Previously Filed Financial Statements as of and for the Year Ended July 31, 2003

      We completed a business combination of entities under common control on August 8, 2003. The transaction was consummated after the end of fiscal year 2003, but before we filed our July 31, 2003 annual report on Form 10-K on October 22, 2003. The Financial Statements have been restated herein to account for this business combination in a manner similar to a pooling-of-interest (see Impact of Acquisitions, below).

 
      One-for-fifteen Reverse Stock Split

      On December 12, 2002, our Board of Directors, pursuant to authority previously granted by our stockholders at the annual meeting on December 19, 2001, approved a reverse stock split of our common stock at a ratio of one-for-fifteen (1:15) effective January 7, 2003. All per-share amounts and number of shares outstanding have been restated to give effect to the reverse stock split.

 
      Change in Controlling Ownership

      Through September 10, 2002, we were a majority owned subsidiary of CMGI, Inc. (CMGI). On September 11, 2002, each of CMGI and Hewlett-Packard Financial Services Company (HPFS) sold and transferred to ClearBlue Technologies, Inc. (ClearBlue), a privately-held managed service provider based in San Francisco, California, the following equity and debt interests in NaviSite:

  •  Pursuant to a Note and Stock Purchase Agreement by and between ClearBlue and CMGI (the CMGI Agreement), CMGI sold and transferred to ClearBlue 4,735,293 shares of our common stock, $0.01 par value per share, representing approximately 76% of the outstanding capital stock of NaviSite, warrants to purchase 346,883 shares of our common stock and a convertible note of NaviSite with an aggregate principal amount outstanding of $10.0 million. The $10.0 million convertible note was convertible into 2,564,103 shares of our common stock, under certain circumstances as defined therein.
 
  •  Pursuant to a Note and Stock Purchase Agreement by and between ClearBlue and HPFS (the HPFS Agreement), HPFS sold and transferred to ClearBlue 213,804 shares of our common stock, representing approximately 3.4% of our outstanding capital stock, and convertible notes of NaviSite with an aggregate principal amount outstanding of approximately $55.0 million, convertible into 14,126,496 shares of our common stock, under certain circumstances as defined therein.

      On December 12, 2002, ClearBlue Finance, Inc., a wholly-owned subsidiary of ClearBlue (ClearBlue Finance), (i) converted in full the $10.0 million note formerly held by CMGI and (ii) converted $10.0 million of the $55.0 million notes formerly held by HPFS. We issued 5,128,205 shares of our common stock to ClearBlue Finance upon the conversion and partial conversion, respectively, of the $10.0 million note formerly held by CMGI and $10.0 million of the $55.0 million notes formerly held by HPFS and issued 458,943 shares of our common stock for payments of interest due under the convertible notes. A new note (New Note) in the amount of $45.0 million was issued to ClearBlue Finance with

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

respect to the portion of the outstanding principal and interest due under the note formerly held by HPFS that was not converted.

      On December 13, 2002, ClearBlue transferred beneficial ownership of all of its shares of our common stock (except for a fractional share which it retained) to its shareholders, ClearBlue Atlantic, LLC (ClearBlue Atlantic), HPFS, CMGI and an employee of ClearBlue Technologies Management, Inc. (CBTM) on a pro rata basis according to its shareholders’ ownership of ClearBlue.

      Also, as a result of the change in ownership, the agreement between NaviSite and CMGI, whereby CMGI provided certain facilities and administrative support services for us, automatically terminated. CMGI continued to provide certain services to us pursuant to a Transition Services Agreement we entered into with CMGI on November 25, 2002 as we transitioned to a service agreement with ClearBlue or to other third-party suppliers. This transition agreement concluded during the second quarter of fiscal year 2003, and we have completely severed our administrative ties with CMGI; however, CMGI remains a third-party customer. During the second quarter of fiscal year 2003, we contracted with ClearBlue and other third-party suppliers for these services.

      On December 31, 2002, NaviSite, a majority owned subsidiary of ClearBlue and its affiliates, completed the acquisition of CBTM, a wholly-owned subsidiary of ClearBlue which, in June 2002, acquired certain assets from the bankrupt estate of AppliedTheory, Inc., in exchange for 567,978 shares of our common stock, representing 4.5% of our total then outstanding common stock, inclusive of the common stock issued as part of the acquisition. The market price of our stock at the time of the transaction was $2.25 per share. As ClearBlue had a controlling interest in both companies at the time of the combination, the transaction was accounted for as a combination of entities under common control (i.e., “as if pooling”) whereby the assets and liabilities of CBTM and NaviSite were combined at their historical amounts. Accordingly, our historical consolidated financial statements have been restated to include the financial results of CBTM beginning on September 11, 2002, the initial date on which ClearBlue acquired a controlling interest in both NaviSite and CBTM. CBTM’s balance sheet has been included in our Consolidated Balance Sheet at July 31, 2003, and CBTM’s results of operations and cash flows for the eleven-months ended July 31, 2003 have been included in our Consolidated Statements of Operations and Consolidated Statements of Cash Flows for the fiscal year ended July 31, 2003. CBTM is operated as a wholly-owned subsidiary of NaviSite.

      On June 16, 2003, we repaid approximately $3.9 million of the $45.0 million of outstanding New Note to ClearBlue Finance, Inc. by offsetting amounts due to us by ClearBlue. On June 17, 2003, we received written notice from ClearBlue Finance, Inc. stating its election to convert the remaining approximately $41.2 million of the New Note into 10,559,248 shares of common stock effective June 19, 2003. As of July 31, 2003 ClearBlue Technologies Equity, Inc., ClearBlue Finance, ClearBlue and ClearBlue Atlantic beneficially owned 19,284,994 shares of our common stock, representing approximately 78.6% of the outstanding shares of common stock on a fully converted basis. As a result of these changes in ownership since September 11, 2002 involving ClearBlue and its affiliates, the utilization of our federal and state tax net operating loss carryforwards will be severely limited pursuant to Internal Revenue Code Section 382.

 
      Impact of Acquisitions

      In addition to the acquisition of CBTM, as discussed above, during fiscal year 2003, we completed the acquisitions of Avasta, Inc., a California corporation (Avasta), Conxion Corporation, a California corporation (Conxion), and substantially all of the assets of Interliant, Inc. (Interliant Assets) through our wholly-owned subsidiary, Intrepid Acquisition Corp. (Intrepid). Each of these acquisitions was accounted for using the purchase method of accounting. The results of operations and cash flows from Avasta, Conxion, and Intrepid are included in our Consolidated Statements of Operations and Consolidated Statements of Cash Flows for the twelve-month period ended July 31, 2003 from their respective dates of

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acquisition, February 5, 2003, April 2, 2003, and May 16, 2003. See Note 6 for further discussion of our fiscal year 2003 acquisitions.

      On August 8, 2003, we completed the acquisition of certain assets and the assumption of certain liabilities of ClearBlue Technologies, Inc. (CBT) pursuant to a Stock and Asset Acquisition Agreement (the CBT Agreement) in a business combination accounted for in a manner similar to a pooling-of-interest due to common control ownership. We acquired all outstanding shares of six (6) wholly-owned subsidiaries of CBT with data centers located in Chicago, Las Vegas, Los Angeles, Milwaukee, Oakbrook and Vienna. In addition, we exercised effective control over and assumed the revenue and expense, as of the date of acquisition, of four (4) additional wholly-owned subsidiaries of CBT with data centers located in Dallas, New York, San Francisco and Santa Clara. Ownership of these subsidiaries will automatically be transferred, under certain conditions, to NaviSite for no additional consideration in February 2004.

      As Atlantic Investors, LLC had a controlling interest in both NaviSite and CBT at the time of the combination, the transaction was accounted for as a combination of entities under common control (i.e., “as if pooling”) whereby the assets and liabilities of CBT and NaviSite were combined at their historical amounts. Accordingly, the Company’s consolidated financial statements have been restated for all periods prior to the business combination to include CBT’s financial results beginning on September 11, 2002, the date on which CBT acquired the controlling interest in the Company after the elimination of intercompany balances. CBT’s balance sheet has been included in the Consolidated Balance Sheet of NaviSite at July 31, 2003, and CBT’s results of operations and cash flows for the eleven months ended July 31, 2003 have been included in the Consolidated Statement of Operations and Consolidated Statement of Cash Flows of NaviSite for the fiscal year ended July 31, 2003.

      (b)     Principles of Consolidation

      The accompanying consolidated financial statements include the accounts of NaviSite and our wholly-owned subsidiaries, ClickHear, Inc., NaviSite Acquisition Corp., ClearBlue Technologies Management, Inc., Avasta, Inc., Conxion Corporation, Intrepid Acquisition Corp., ClearBlue Technologies/ Chicago-Wells, Inc., ClearBlue Technologies/ Las Vegas, Inc., ClearBlue Technologies/ Los Angeles, Inc., ClearBlue Technologies/ Milwaukee, Inc., ClearBlue Technologies/ Oakbrook, Inc., and ClearBlue Technologies/ Vienna, Inc. after elimination of all significant intercompany balances and transactions.

      (c)     Use of Estimates

      The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect certain reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Significant estimates made by management include the useful lives of fixed assets and intangible assets, recoverability of long-lived assets and the collectibility of receivables.

      (d)     Cash and Cash Equivalents

      Cash equivalents consist of a money market fund, which invests in high quality short-term debt obligations, including commercial paper, asset-backed commercial paper, corporate bonds, U.S. government agency obligations, taxable municipal securities, and repurchase agreements.

      During fiscal year 2003, non-cash financing activities included the repayment of approximately $3.9 million of the New Note to ClearBlue Finance, Inc. with amounts due us by ClearBlue. In addition, fiscal year 2003 non-cash financing activities included the conversion of the then outstanding $41.2 million New Note into 10,559,248 shares of our common stock. This conversion also resulted in non-cash charges

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

of (a) $195,000 related to deferred financing costs; (b) $2.7 million in deferred interest expense; and (c) $21.6 million related to the amortization of the remaining balance of the beneficial conversion feature.

      During fiscal year 2002, non-cash financing activities included a $35.0 million obligation to Compaq Financial Services Corporation, a wholly-owned subsidiary of Compaq Computer Corporation subsequently acquired by HPFS, incurred for the purchase of equipment previously held under operating lease agreements with a fair value, based on a third-party appraisal, of $9.6 million.

      During fiscal year 2002, non-cash financing activities included the conversion of the $70.9 million, net, carrying amount ($80.0 million face value) of convertible notes payable to CMGI including interest of $1.5 million, and $16.2 million of amounts due to CMGI into an aggregate of 1,641,993 shares of our common stock.

      During fiscal 2002 and 2001, non-cash financing activities included the issuance of 464,800 and 186,000 shares of common stock, respectively, in satisfaction of interest associated with convertible notes outstanding during fiscal 2002 and 2001.

      In August 2002, the Company settled its intercompany liability to and receivables from CMGI, as of May 31, 2002, for $3.2 million in cash. The $3.2 million was remitted to CMGI in August 2002. As a result of the transaction, the Company realized a $4.5 million gain on the settlement, which was recorded as a contribution to additional paid-in capital as of July 31, 2002 as the transaction was considered to be a settlement of debt between entities under common control.

      (e)     Revenue Recognition

      Revenue consists of monthly fees for Web site and Internet application management, application rentals, hosting, and professional services. Revenue (other than installation fees) is generally billed and recognized over the term of the contract, generally one to three years, based on actual usage. Payments received in advance of providing services are deferred until the period such services are provided. Revenue from professional services is recognized on a time-and-material basis as the services are performed or under the percentage of completion method for revenue relating to fixed-price contracts. We generally sell our professional services under contracts with terms ranging from one to five years. Revenue and profits on long-term Internet solutions contracts, which represent approximately 3.0% of total revenues for the fiscal year period ended July 31, 2003, performed over extended periods are recognized under the percentage-of-completion method of accounting, principally, with adjustments recorded in the period in which the revisions are made. Any anticipated losses on contracts are charged to operations as soon as they are determinable.

      (f)     Concentration of Credit Risk

      Our financial instruments include cash, accounts receivable, obligations under capital leases, software agreements, accounts payable, and accrued expenses. As of July 31, 2003, the carrying cost of these instruments approximated their fair value. The financial instruments that potentially subject us to concentration of credit risk consist primarily of accounts receivable. Concentration of credit risk with respect to trade receivables is limited due to the large number of customers across many industries that comprise our customer base. One third-party customer accounted for 21% of our total revenues for the twelve-months ended July 31, 2003. Accounts receivable at July 31, 2003 included approximately $2.3 million due from this third-party customer.

      (g)     Comprehensive Income (Loss)

      Comprehensive income (loss) is defined as the change in equity from foreign currency translation adjustments.

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      (h)     Property and Equipment

      Property and equipment are stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. Leasehold improvements and assets acquired under capital leases are amortized using the straight-line method over the shorter of the lease term or estimated useful life of the asset. Assets acquired under capital leases in which title transfers to us at the end of the agreement are amortized over the useful life of the asset. Expenditures for maintenance and repairs are charged to expense as incurred.

      (i)     Goodwill and Intangible Assets

      Prior to July 31, 2002, goodwill related to purchase acquisitions completed in fiscal years 1998 and 2000. Such costs were amortized on a straight-line basis over five years, the period expected to be benefited. In fiscal year 2002, goodwill of $3,400 was written-off as part of the sale of the majority of the operating assets of one of the prior acquisitions. As part of our impairment analysis performed at July 31, 2002, it was determined that the unamortized goodwill at July 31, 2002 of $186,000 was fully impaired and was included in the accompanying consolidated statements of operations as a component of general and administration expense.

      At July 31, 2003, our intangible assets consisted of customer lists resulting from our acquisition of CBTM, and the acquisitions of the certain assets and liabilities of Interliant and CBT. Our intangible assets were recorded at a gross carrying value of $15.8 million, less accumulated amortization of $3.7 million at July 31, 2003. Amortization expense related to our customer lists of $3.2 million for the fiscal year period ended July 31, 2003 was recorded as a component of our cost of revenue. Goodwill, resulting from our acquisition of CBTM, is recorded at its gross carrying value of $3.2 million. We perform our annual impairment analysis in our fiscal fourth quarter.

      (j)     Accounting for Impairment of Long-Lived Assets

      We assess the need to record impairment losses on long-lived assets used in operations when indicators of impairment are present. On an ongoing basis, management reviews the value and period of amortization or depreciation of long-lived assets, including goodwill. During this review, the significant assumptions used in determining the original cost of long-lived assets are reevaluated. Although the assumptions may vary from transaction to transaction, they generally include revenue growth, operating results, cash flows, and other indicators of value. Management then determines whether there has been a permanent impairment of the value of long-lived assets by comparing future undiscounted cash flows to the asset’s carrying value. If the estimated future undiscounted cash flows are less than the carrying value of the asset, a loss is recorded based on the excess of the asset’s carrying value over fair value.

      (k)     Income Taxes

      We account for income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

      Prior to the initial public offering on October 21, 1999, we were greater than 80% owned by CMGI, and as such, CMGI realized the full benefit of all federal and part of the state net operating losses that had been incurred by us for those periods before the fiscal year ended July 31, 2001. Therefore, such net operating losses incurred by NaviSite were not available to us. The tax sharing agreement between NaviSite and CMGI required us to reimburse CMGI for the amounts it contributed to the consolidated

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

tax liability of the CMGI group; however, under the policy, CMGI was not obligated to reimburse us for any losses utilized in the consolidated CMGI group. After our public offering, CMGI’s ownership fell below 80% and we were no longer included in the federal consolidated group of CMGI. Thus, our federal and state net operating losses can be carried forward to offset our future taxable income. As a result of the transaction on September 11, 2002, NaviSite had a change in ownership as defined in Section 382 of the Internal Revenue Code. As a result of the change in ownership, the utilization of its federal and state tax net operating losses generated prior to the transaction is severely limited.

      (l)     Advertising Costs

      We recognize advertising costs as incurred. Advertising expense was approximately $0, $4,000, and $3.1 million for the fiscal years ended July 31, 2003, 2002, and 2001, respectively, and is included in the accompanying consolidated statements of operations as a component of selling and marketing expenses.

      (m)     Stock-Based Compensation Plans

      We account for our stock option plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based compensation cost is reflected in net income for these plans, as all options granted under these plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income (loss) and earnings (loss) per share if we had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock based compensation.

                         
2003 2002 2001



(In thousands, except per share data)
Net loss, as reported
  $ (73,627 )   $ (121,693 )   $ (122,996 )
Deduct: Total stock based employee compensation expense determined under fair value based method for all awards, net of related tax effects
    (8,062 )     (24,778 )     (40,072 )
     
     
     
 
Net loss, as adjusted
  $ (81,689 )   $ (146,471 )   $ (163,068 )
     
     
     
 
Loss per share:
                       
Basic and diluted — as reported
  $ (6.32 )   $ (22.30 )   $ (31.27 )
Basic and diluted — as adjusted
  $ (7.01 )   $ (26.84 )   $ (41.46 )
NaviSite:
                       
Risk-free interest rate
    1.93 %     2.23 %     4.50 %
Expected dividend yield
    0.00 %     0.00 %     0.00 %
Expected volatility
    160.16 %     250.00 %     185.10 %
Expected life (years)
    3.07       2.12       2.08  
Weighted average fair value of options granted during the period
  $ 2.56     $ 4.35     $ 219.30  
CMGI:
                       
Risk-free interest rate
    2.79 %     2.79 %     4.19 %
Expected dividend yield
    0.00 %     0.00 %     0.00 %
Expected volatility
    97.05 %     97.05 %     126.95 %
Expected life (years)
    5.85       5.85       2.91  
Weighted average fair value of options granted during the period
    N/A       N/A       N/A  

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
     (n) Historical and Unaudited Pro Forma Basic and Diluted Net Loss Per Share

      Basic earnings (loss) per share is computed using the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per share is computed using the weighted average number of common and diluted common equivalent shares outstanding during the period, using either the “if-converted” method for convertible preferred stock and notes or the treasury stock method for options, unless amounts are anti-dilutive.

      For fiscal years ended July 31, 2003, 2002, and 2001, net loss per basic and diluted share is based on weighted average common shares and excludes any common stock equivalents, as they would be anti-dilutive due to the reported losses. There were 2,741, 29,503 and 167,793 of diluted shares related to employee stock options that were excluded as they have an anti-dilutive effect due to the loss for fiscal years 2003, 2002, and 2001 respectively.

 
     (o) Segment Reporting

      We currently operate in one segment, outsourced hosting and application management services. The Company’s chief operating decision maker reviews financial information at a consolidated level. The Company has determined that reporting revenue at a service offering level is impracticable.

 
     (p) New Accounting Pronouncements

      In May 2003, the Financial Accounting Standards Board (FASB) finalized Emerging Issues Task Force (EITF) Issue 01-8, “Determining Whether an Arrangement is a Lease” (EITF 01-8). Under EITF 01-8, our relationships with our customers no longer meet the definition of a lease arrangement and as such, on a prospective basis after May 31, 2003, we no longer account for new customer agreements as direct financing agreements. Customer agreements that were classified as direct financing agreements before June 1, 2003 will continue to be treated as direct financing agreements through the term of the agreements.

      In June 2001, the FASB issued SFAS No. 141, “Business Combinations”, and SFAS No. 142, “Goodwill and Other Intangible Assets”. SFAS No. 141 applies to all business combinations that we enter into after June 30, 2001, and eliminates the pooling-of-interests method of accounting. SFAS No. 142 is effective for fiscal years beginning after December 15, 2001. Under the new statements, goodwill and intangible assets deemed to have indefinite lives will no longer be amortized but will be subject to annual impairment tests in accordance with the statements. Other intangible assets will continue to be amortized over their useful lives.

      During the first quarter of fiscal 2003 (effective August 1, 2002), the Company adopted Statement of Financial Accounting Standards No. 142 (SFAS 142), “Goodwill and Intangible Assets”, which supersedes APB Opinion No. 17, “Intangible Assets”. SFAS No. 142 eliminates the current requirement to amortize goodwill and indefinite-lived intangible assets, addresses the amortization of intangible assets with a defined life and addresses the impairment testing and recognition of goodwill and intangible assets. The following information describes the impact that the adoption of SFAS No. 142 had on the Company for the fiscal years ended July 31:

Intangible Assets:

      Intangible assets as of July 31, 2003 are as follows:

                 
Gross Carrying Accumulated
Amount Amortization


(In thousands)
Customer Lists
  $ 15,776     $ 3,724  

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      The accumulated amortization of $3.7 million above includes $507,000 of accumulated amortization relating to the CBT customer lists (acquired in fiscal year 2004), which were accounted for in a manner similar to a pooling-of-interest due to common control ownership. Intangible asset amortization expense for the years ended July 31, 2003, 2002, and 2001 aggregated $3.2 million, $0 and $0 respectively. Amortization expense related to intangible assets for the next five years is as follows:

         
Year Ending July 31, (In thousands)


2004
  $ 3,232  
2005
  $ 2,940  
2006
  $ 2,577  
2007
  $ 1,627  
2008
  $ 1,047  

Goodwill:

      The changes in the carrying amount of goodwill for the fiscal years ended July 31 are as follows:

                         
Fiscal Fiscal Fiscal
2003 2002 2001



(In thousands)
Goodwill as of August 1
  $     $ 394     $ 601  
Goodwill acquired
    3,206              
Goodwill amortization
          (208 )     (207 )
Goodwill impairment
          (186 )      
     
     
     
 
Goodwill as of July 31
  $ 3,206     $     $ 394  
     
     
     
 

      The impact that the adoption of SFAS 142 had on net income and earnings per share for the fiscal years ended July 31 are presented as follows:

                           
2003 2002 2001



(In thousands)
Net loss
  $ (73,627 )   $ (121,693 )   $ (122,996 )
Add back goodwill amortization
          208       207  
     
     
     
 
Adjusted net loss
  $ (73,627 )   $ (121,485 )   $ (122,789 )
     
     
     
 
Basic and diluted earnings per share:
                       
 
Net loss
  $ (6.32 )   $ (22.30 )   $ (31.27 )
 
Goodwill amortization
          0.05       0.04  
     
     
     
 
Adjusted net loss
  $ (6.32 )   $ (22.25 )   $ (31.23 )
     
     
     
 

      SFAS No. 143, “Accounting for Asset Retirement Obligations”, issued in August 2001, addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and was adopted beginning in the first quarter of fiscal year 2003. The adoption of SFAS 143 did not have a material impact on our financial condition or results of operations.

      SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, issued in October 2001, addresses financial accounting and reporting for the impairment or disposal of long-lived assets and is effective for fiscal years beginning after December 15, 2001. SFAS 144 establishes a single accounting model for long-lived assets to be disposed of by sale as well as revising certain criteria specified in

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SFAS 121 for the recognition and measurement of impairment losses related to long-lived assets. The adoption of SFAS 144 did not have a material impact on our financial condition or results of operations.

      SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities”, issued in July 2002, addresses financial accounting and reporting for costs associated with exit or disposal activities and rescinds Emerging Issues Task Force (EITF) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)”. SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Under EITF Issue No. 94-3, a liability for an exit cost as defined in EITF Issue No. 94-3 was recognized at the date of an entity’s commitment to an exit plan. SFAS 146 also establishes that fair value is the objective for initial measurement of the liability. The provisions of SFAS 146 are effective for exit and disposal activities that are initiated after December 31, 2002. We applied the provisions of SFAS 146 in January 2003 in connection with the lease abandonments.

      In November 2002, the FASB issued Interpretation No. 45 (FIN 45), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others”, which clarifies disclosure and recognition/ measurement requirements related to certain guarantees. The disclosure requirements are effective for financial statements issued after December 15, 2002 and the recognition/ measurement requirements are effective on a prospective basis for guarantees issued or modified after December 31, 2002. The application of the requirements of FIN 45 did not have a material impact on our financial position or results of operations.

      In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure”. SFAS No. 148 amends SFAS No. 123 to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The transition guidance and annual disclosure provisions of SFAS No. 148 are effective for fiscal years ending after December 15, 2002. The interim disclosure provisions are effective for financial reports containing financial statements for interim periods beginning after December 15, 2002. As we did not make a voluntary change to the fair value based method of accounting for stock-based employee compensation in fiscal year 2003, the adoption of SFAS No. 148 did not have a material impact on the our financial position and results of operations.

      In May 2003, the FASB issued SFAS 150, “Accounting For Certain Financial Instruments with Characteristics of Both Liabilities and Equity” which establishes standards for how an issuer of financial instruments classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) if, at inception, the monetary value of the obligation is based solely or predominantly on a fixed monetary amount known at inception, variations in something other than the fair value of the issuer’s equity shares or variations inversely related to changes in the fair value of the issuer’s equity shares. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS 150 is not expected to have a material impact on our financial position or results of operations.

 
(q)     Reclassifications

      Certain fiscal year 2002 balances have been reclassified to conform with the fiscal year 2003 financial statement presentation.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
     (r) Foreign Currency

      The functional currencies of our wholly-owned subsidiaries are the local currencies. The financial statements of the subsidiaries are translated into U.S. dollars using period-end exchange rates for assets and liabilities and average exchange rates during corresponding period for revenues, cost of revenues and expenses. Translation gains and losses are deferred and accumulated as a separate component of stockholders’ equity (accumulated other comprehensive income (loss).

 
(3) Liquidity

      Our cash and cash equivalents decreased to approximately $3.9 million at July 31, 2003 from approximately $21.8 million at July 31, 2002. Net cash used in operating activities was approximately $14.5 million for the year ended July 31, 2003, resulting primarily from net losses, decreases in accrued expenses and accounts payables, and a decrease in amounts due to CMGI, partially offset by non-cash charges for the write-off and amortization of the beneficial conversion feature of the convertible debt, interest paid in stock, costs related to abandoned leases, impairment of assets, depreciation and amortization, and provision for bad debt. Net cash used in investing activities was approximately $1.9 million for the year ended July 31, 2003, resulting primarily from purchases of property and equipment, the purchase of certain assets of Interliant, the purchase of convertible notes of Interliant, a loan made to a related party, partially offset by cash acquired in acquisitions and the release of restricted cash. Net cash used for financing activities was approximately $1.5 million for the fiscal year ended July 31, 2003, resulting primarily from repayment of debt to the estate of AppliedTheory, repayment of notes to affiliates, the payment of capital lease obligations, partially offset by borrowings from affiliates and borrowings from our accounts receivable financing line.

      At July 31, 2003, we had a working capital deficit of $16.3 million, an accumulated deficit of $416 million, and have reported losses from operations since incorporation. We have used cash from continuing operations of $14.5 million, $27.0 million and $88.8 million in the years ended July 31, 2003, 2002, and 2001, respectively. We anticipate incurring additional losses throughout our next fiscal year. NaviSite has taken several actions it believes will allow us to continue as a going concern through July 31, 2004, including the closing and integration of strategic acquisitions, the change in our Board of Directors and senior management and bringing costs more in line with projected revenues. Based upon our cash flow estimates we believe that we will more than likely need to raise funds to meet our anticipated needs for working capital and capital expenditures for at least the next twelve months. Our cash flow estimates are based upon attaining certain levels of sales, maintaining budgeted levels of operating expenses, collections of accounts receivable and maintaining our current borrowing line with Silicon Valley Bank among other assumptions, including the improvement in the overall macroeconomic environment. Our sales estimate includes revenue from new and existing customers which may not be realized and we may be required to further reduce expenses if budgeted sales are not attained. We may be unsuccessful in reducing expenses in proportion to any shortfall in projected sales and our estimate of collections of accounts receivable may be hindered by our customers’ ability to pay.

      We believe that we will more than likely need to raise funds to meet our anticipated needs for working capital and capital expenditures. We believe that the sources of liquidity include the issuance of equity or convertible debt securities, sales of assets, or through credit arrangements with financial institutions. If we are unable to successfully complete any one of such capital-raising transactions, we will turn to one or more of the other transactions. The accompanying consolidated financial statements have been prepared assuming NaviSite will continue as a going concern and, as such, do not include any adjustments that may result from the outcome of these uncertainties.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
(4) Impairment of Long-Lived Assets

      During fiscal year 2002, the Company recorded a net $1.9 million charge representing the future estimated remaining minimum lease payments related to certain idle equipment held under various operating leases. The equipment had previously been rented to former customers under operating leases, and upon the loss of the customer, the equipment became idle. Based on the Company’s forecasts, the equipment will not be utilized before the related operating leases expire and/or the equipment becomes obsolete.

      During fiscal year 2002, the Company evaluated the current and forecasted utilization of its purchased software licenses. As a result of this evaluation, during the second quarter of fiscal year 2002, the Company recorded a $365,000 impairment for software licenses that would not be utilized before the licenses expired or became obsolete.

      During fiscal year 2002, the Company finalized agreements with various equipment lessors whereby the Company purchased equipment previously held under operating lease for approximately $42.0 million. The fair market value of the equipment at the time of purchase, based on third party appraisal, was approximately $13.1 million. As the aggregate fair market value of the equipment, based on third party appraisal, was less than the aggregate consideration given, the Company recorded an asset impairment charge of $25.4 million, as a separate component of cost of revenue, in fiscal year 2002.

      A number of factors occurring during the fourth quarter of fiscal 2002 impacted the Company’s long-lived assets including both their expected future cash flow generation and the Company’s expected utilization of the assets within revised operating plans. These factors included the further deterioration of market conditions within the web hosting industry, excess capacity in the industry and in the Company’s two data centers, deterioration of the Company’s revenue base.

      Based on these factors and their impact on current and future projected cash flows, the Company performed an assessment of the carrying value of its long-lived assets pursuant to SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of.” The conclusion of this assessment was that the decline in market conditions within the Company’s industry were significant and other than temporary. In this assessment, the Company reviewed its long-lived assets, which included property and equipment and goodwill. The carrying amount of goodwill, which totaled $186,000, was considered unrecoverable and was written-off as of July 31, 2002 and was included as a component of general and administration expense.

      In accordance with SFAS No. 121, the measurement of the impairment loss of property and equipment was based on the fair value of the asset, as determined by a third party appraisal. The following is a summary of the impairment charge, by asset classification, as of July 31, 2002:

                           
Appraised
Carrying Value Fair Value Impairment



(In thousands)
Office furniture and equipment
  $ 3,062     $ 837     $ 2,225  
Computer equipment
    8,470       5,675       2,795  
Software licenses
    3,720       2,158       1,562  
Leasehold improvements
    35,280       3,742       31,538  
     
     
     
 
 
Total
  $ 50,532     $ 12,412     $ 38,120  
     
     
     
 

      In addition, approximately $3.0 million of other impairment charges were recorded throughout the year as appropriate.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      Management determined that the best measure of fair value for the property and equipment was a combination of the market and cost approaches. The cost approach was utilized to determine the fair value of certain computer hardware, leasehold improvements, office furniture and equipment, and construction in progress. The cost approach utilizes estimated replacement/reproduction costs, with allowances for physical depreciation and functional obsolescence (i.e. asset utilization). For certain equipment and leasehold improvements, the market approach was used. The market approach typically includes comparing recent sales of similar assets and adjusting these comparable transactions based on factors such as age, condition, and type of sale to determine fair value.

      The following is a summary of the fiscal 2002 impairment charges described above, by asset classification:

           
Net impairment of fixed assets purchased from operating leases
  $ 24,881  
Impairment of software that would not be utilized before expiration of license or software became obsolete
    365  
Impairment of idle leased equipment
    1,937  
Impairment of fixed assets under SFAS 121 based on the fair value of the assets versus the carrying value
    41,134  
     
 
 
Total
  $ 68,317  
     
 

      All impairment charges were recorded in the consolidated statements of operations based upon the nature of the asset being impaired and the nature of the asset’s use. The impairments recorded as a separate component of cost of revenue related to assets that were either being utilized or had at some time been utilized to generate revenue. The determination was based upon how the assets had historically been expensed, either as lease expense or depreciation/ amortization.

      As a result of our abandoning our administrative space located on the second floor of our leased facility at 400 Minuteman Road in Andover, MA on January 31, 2003, certain long-lived assets consisting mostly of leasehold improvements and furniture and fixtures were abandoned. We took a charge against our earnings in the second quarter of fiscal 2003 of approximately $62,000 in accordance with SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”

      During the third fiscal quarter of 2003, we evaluated the net realizable value of our assets held for sale and determined, based upon third party quotes for purchase of these assets, that the net fair market value of our assets held for sale was less than the carrying value. As a result, we recorded a $1.0 million charge related to the reduction in the net realizable value of our assets held for sale as a component of other expense. These assets were sold to third parties in the fourth fiscal quarter of 2003.

      During the fourth quarter of 2003, we evaluated the net realizable value of our intangible assets and determined, due to changes in certain real estate markets where we operate, that the net fair market value of our market advantaged leases was less than the carrying value. As a result, we recorded a charge of approximately $1.8 million related to the impairment of the market advantage leases.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
(5) Property and Equipment

      Property and equipment at July 31, 2003 and 2002 are summarized as follows:

                 
July 31,

2003 2002


(In thousands)
Office furniture and equipment
  $ 2,613     $ 1,232  
Computer equipment
    28,368       15,237  
Software licenses
    9,308       8,982  
Leasehold improvements
    12,549       3,717  
     
     
 
      52,838       29,168  
Less accumulated depreciation and amortization
    (30,673 )     (16,756 )
     
     
 
Property and equipment, net
  $ 22,165     $ 12,412  
     
     
 

      The estimated useful lives of our fixed assets are as follows: office furniture and equipment, 5 years; computer equipment, 3 years; software licenses, 3 years or life of the license; and leasehold improvements, 4 years or life of the lease.

      The cost and related accumulated amortization of property and equipment held under capital leases (classified as computer equipment above) are as follows:

                 
July 31,

2003 2002


(In thousands)
Cost
  $ 6,349     $ 457  
Accumulated depreciation and amortization
    (2,181 )     (189 )
     
     
 
    $ 4,168     $ 268  
     
     
 
 
(6) Acquisitions

      CBTM. We acquired CBTM in December 2002 in a transaction accounted for as a combination of entities under common control (i.e., “as if pooling”) (see Note 1). In June 2002, prior to our acquisition of CBTM, CBTM acquired substantially all of the assets used or useful in the web hosting and Internet solutions business and assumed certain associated liabilities from the bankruptcy estate of AppliedTheory Corporation (AppliedTheory), which had filed for bankruptcy on April 17, 2002. On June 13, 2002, the acquisition of AppliedTheory by CBTM was consummated, effective June 6, 2002. The results of operations of AppliedTheory have been included in the financial statements of CBTM since June 6, 2002.

      The aggregate purchase price paid by CBTM for the AppliedTheory assets, excluding assumed liabilities, was $16.0 million of which $3.9 million was paid in cash and $12.1 million was paid with the issuance of four notes payable to the AppliedTheory Estate: two unsecured promissory notes totaling $6.0 million, bearing interest at 8% per annum and due June 10, 2006, a secured promissory note totaling $700,000, bearing interest at 8% per annum and due December 10, 2002 and a $5.4 million secured promissory note, non-interest bearing, due December 10, 2002. The two notes due December 10, 2002 were paid in December 2002.

      Of the $6.2 million in identifiable intangible assets, $5.8 million was assigned to customer lists which are being amortized over eight years, except for the New York State Department of Labor customer contract, which is being amortized over five years, and represents the remaining life on the contract. The

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

remaining $440,000 of acquired intangible assets was allocated to proprietary software, which is being amortized over five years.

      Avasta, Inc. On February 5, 2003, we acquired Avasta, a provider of remote hosting and managed service operations in an all-stock transaction valued at approximately $370,000. The acquisition was made to enhance our ability to be a full service provider of applications management services and technology to our customers. The purchase price consisted of 231,039 shares of common stock at a per share value of $1.60 (representing a five-day average of the market value of our common stock at the time of the acquisition). The purchase price of $442,000 consists of the issuance of common stock for approximately $370,000 and approximately $72,000 in acquisition costs. The Agreement and Plan of Merger provided that up to an additional 1,004,518 shares of common stock could be issued in the event certain revenue targets are achieved through June 2003. As a result of the earnout calculation, in September 2003 we issued 179,353 shares of our common stock at a per share value of $4.14 (representing the market value of our common stock the day preceding the issuance of the additional shares for the attainment of certain revenue targets). The negative goodwill of approximately $342,000 reduced the recorded basis of property and equipment. This acquisition was accounted for using the purchase method of accounting.

      The following table summarizes the fair value of the assets acquired and liabilities assumed at the date of acquisition:

         
Avasta

(In thousands)
Current assets
  $ 488  
Property and equipment
    3,239  
     
 
Total assets acquired
    3,727  
Current liabilities
    3,285  
Long-term debt
     
     
 
Total liabilities assumed
    3,285  
     
 
Net assets acquired
  $ 442  
     
 

      Conxion Corporation. On April 2, 2003, we completed the acquisition of Conxion, a provider of software distribution services and network/server security expertise for its customers, pursuant to an Agreement and Plan of Merger, dated as of March 26, 2003 (Conxion Agreement), by and between us, Union Acquisition Corp., a Delaware corporation and our wholly-owned subsidiary and Conxion. Pursuant to the Conxion Agreement, the shareholders of Conxion received an aggregate of $1.9 million in cash. The acquisition was made to enhance our ability to be a full service provider of applications management services and technology to our customers. The source of funds used for the acquisition of Conxion was our cash on hand. The acquisition price was based on the parties’ determination of the fair value of Conxion and the terms of the Conxion Agreement were derived from arms-length negotiation among the parties. The purchase price of $2.0 million consisted of the $1.9 million paid to the Conxion shareholders and approximately $106,000 in acquisition costs. The negative goodwill of approximately $2.5 million reduced the recorded basis of property and equipment. This acquisition was accounted for using the purchase method of accounting.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      The following table summarizes the fair value of the assets acquired and liabilities assumed at the date of acquisition:

         
Conxion

(In thousands)
Current assets
  $ 7,819  
Property and equipment
    187  
     
 
Total assets acquired
    8,006  
Current liabilities
    5,976  
Long-term debt
     
     
 
Total liabilities assumed
    5,976  
     
 
Net assets acquired
  $ 2,030  
     
 

      Interliant. On May 16, 2003, we completed the acquisition of substantially all of the assets relating to the managed infrastructure solutions business, encompassing messaging and collaboration, managed hosting, bundled-in managed security, and integrated and related professional services in the United States and in Europe of Interliant, Inc., a Delaware corporation, and several of its subsidiaries (Debtors) in the bankruptcy proceedings of the Debtors under Chapter 11 of Title 11 of the United States Bankruptcy Code pending in the Southern District of New York (White Plains), pursuant to an Asset Purchase Agreement, dated as of May 15, 2003 (the Agreement), by and between our subsidiary, Intrepid Acquisition Corp. and the Debtors, approved by order of the Bankruptcy Court on May 15, 2003. Pursuant to the Agreement, the aggregate purchase price for the Interliant assets was approximately $7.2 million after adjustments, based upon the Debtors’ adjusted net worth, comprised of approximately $5.8 million in cash, $624,000 in the form of a credit of future distributions to be paid on the Interliant Notes, $550,000 in principal amount of a non-interest bearing, 180-day promissory note, secured by the Interliant Debt and approximately $200,000 in acquisition-related costs. On May 16, 2003, our subsidiary closed on the purchase of all of the Interliant Assets, other than the Debtors’ accounts receivable. On June 6, 2003 our subsidiary closed on the purchase of the accounts receivable. The source of funds used for the initial closing was our cash on hand combined with the funds provided from and through financing of our accounts receivable with Silicon Valley Bank (SVB), as discussed below, cash acquired with the Interliant assets, and cash receipts from the purchased accounts receivable. The acquisition price was determined through arms-length negotiations and competitive bidding for the Interliant Assets at an auction conducted under the auspices of the Bankruptcy Court. Finalization of the purchase accounting is pending resolution of the net worth calculation. However, we do not believe that any adjustment relating to this matter will be material to our consolidated financial statements.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      The following table summarizes the fair value of the assets acquired and liabilities assumed at the date of acquisition:

         
Interliant

(In thousands)
Current assets
  $ 3,966  
Long-term assets
    5,940  
Property and equipment
    2,178  
     
 
Total assets acquired
    12,084  
Current liabilities
    4,880  
Long-term debt
     
     
 
Total liabilities assumed
    4,880  
     
 
Net assets acquired
  $ 7,204  
     
 

      On August 8, 2003, we completed the acquisition (the “CBT Acquisition”) of certain assets and the assumption of certain liabilities of ClearBlue Technologies, Inc., a Delaware corporation (ClearBlue), pursuant to a Stock and Asset Acquisition Agreement, dated as of August 8, 2003 (the “Agreement”). At the time of the Agreement, we were a majority owned subsidiary of ClearBlue and its affiliates. See Notes 2(a) and 16 for further discussion.

      The following unaudited pro forma results of operations for the twelve-months ended July 31, 2003 and 2002 give effect to CBTM’s acquisition of AppliedTheory assets, our fiscal year 2003 acquisitions and the CBT Acquisition as if the transactions had occurred at the beginning of fiscal year 2002. The pro forma information does not necessarily reflect the results of operations that would have occurred had the acquisitions taken place at the beginning of the fiscal 2002 period and is not necessarily indicative of results that may be obtained in the future.

                 
Year Ended July 31,

2003 2002


(In thousands, except for
per share amounts)
Revenue
  $ 113,528     $ 197,726  
Net loss before extraordinary items
    (88,502 )     (321,919 )
Net loss
    (88,502 )     (286,962 )
Pro forma net loss per share
  $ (7.59 )   $ (52.59 )

(7)     Investment in Debt Securities

      In a privately negotiated transaction with Fir Tree Recovery Master Fund, LP and Fir Tree Value Partners, LDC, pursuant to an Assignment Agreement dated October 11, 2002 and in a series of open market transactions from certain other third-party holders, we acquired an aggregate principal amount of approximately $36.3 million face value, 10% convertible senior notes (Interliant Notes) due in 2006 of Interliant, Inc. (Interliant) for a total consideration of approximately $2.0 million. Interliant is a provider of managed services, which filed a petition under Chapter 11 of Title 11 of the United States Bankruptcy Code in the Southern District of New York on August 5, 2002, and we made this investment with the intention of participating in the reorganization/sale of Interliant.

      On May 16, 2003, the Southern District of New York (White Plains) confirmed us as the successful bidder for the purchase of the Interliant Assets (see Note 6). We used $624,000 of the value of our

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Interliant Notes as partial payment for the assets acquired. As such, we have reduced the carrying value of the Interliant Notes by this amount. The final value we will receive for the Interliant Notes has not been determined, however, we estimate the value to approximate the $1.4 million carrying value included in other assets on our Consolidated Balance Sheet. The Interliant Estate has filed a plan of liquidation with the bankruptcy court which is subject to creditor approval and resolution of further contested claims.

(8)     Accrued Expenses

      Accrued expenses consist of the following:

                 
July 31,

2003 2002


(In thousands)
Accrued payroll, benefits and commissions
  $ 3,088     $ 2,037  
Accrued accounts payable
    3,694       1,328  
Due to AppliedTheory estate
    1,461        
Accrued lease abandonment costs
    2,536       189  
Accrued interest
    351       1,565  
Accrued contract termination fees
    2,096        
Accrued other
    4,354       2,813  
     
     
 
    $ 17,580     $ 7,932  
     
     
 

(9)     Debt

     (a)     Convertible Notes Payable

      On September 11, 2002, CMGI and HPFS sold their equity and convertible interests in NaviSite to ClearBlue Technologies, Inc. (ClearBlue). Subsequent to July 31, 2002, we had not paid the interest payable on the Notes due on September 30, 2002. We were also no longer listed on the Nasdaq National Market and were instead listed on the Nasdaq SmallCap Market. Pursuant to the Notes, this new listing on the Nasdaq SmallCap Market requires us to seek ClearBlue’s prior written consent before paying interest and principal in the form of common stock. On October 10, 2002, we received a waiver from ClearBlue permitting the payment of interest to be made in the form of stock consistent with our listing on the Nasdaq SmallCap Market and the waiver for any noncompliance of timely payments of interest or principal and we paid the interest due to ClearBlue.

      On December 12, 2002, ClearBlue gave us the right, at our option, to prepay 100% of the interest accrued at December 12, 2002 on the New Note in shares of our common stock. On December 12, 2002, we paid approximately $1.1 million of interest owing on the balance of the New Note with 317,932 shares of our common stock. In addition, ClearBlue waived all interest for the period December 12, 2002 through December 31, 2003 resulting from the unconverted notes. We recognized an imputed interest charge for this interest free period.

      In connection with ClearBlue Finance’s conversion of $20.0 million of convertible notes to common stock (see Note 2), $10.7 million of the unamortized beneficial conversion related to the converted notes was charged to interest expense during the second fiscal quarter of 2003. As part of the conversion of the converted notes, $469,000 in accrued interest related to the Converted Notes was converted into approximately 141,011 shares of our common stock.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      On June 16, 2003, we repaid approximately $3.9 million of the $45.0 million of outstanding New Note payable to ClearBlue Finance with amounts due to us by ClearBlue. The $3.9 million consisted of $1.9 million of intercompany amounts due to us by ClearBlue and a $2.0 million ClearBlue note payable to us. On June 17, 2003, we received written notice from ClearBlue Finance stating its election to convert the remaining $41.2 million of the New Note into 10,559,248 shares of our common stock effective June 19, 2003. Concurrent with the conversion, in the fourth fiscal quarter of 2003 we realized a $21.6 million interest charge for the unamortized beneficial conversion feature related to the converted and repaid convertible notes payable. ClearBlue had previously waived all interest for the period December 12, 2002 through December 31, 2003 on the $45.0 million of convertible notes payable and, accordingly, we had been accruing an imputed interest expense for this period. Subsequent to the conversion, in the fourth fiscal quarter of 2003, we recorded a $2.6 million contribution to additional paid in capital for the imputed accrued interest on the converted and repaid convertible notes payable, as ClearBlue is a related party.

      In fiscal year 2002, the Company issued 446,724 shares of common stock in satisfaction of accrued interest associated with the $65.0 million notes payable to CMGI and HPFS.

     (b)     Accounts Receivable Financing Agreements

      On May 26, 2003, we entered into an Accounts Receivable Financing Agreement (Financing Agreement) with SVB whereby we can finance up to a maximum of $12.5 million of our eligible accounts receivables with an 80% advance rate. Under the Financing Agreement, we are required to repay advances upon the earlier of our receipt of payment on the financed accounts receivables from our customers, or the financed accounts receivable being aged greater than ninety days from date of service. The Financing Agreement has a one-year term and bears an annual interest rate of prime rate plus 4.0%, with a minimum $10,000 monthly finance charge. The Financing Agreement also contains certain affirmative and negative covenants and is secured by substantially all of our assets, tangible and intangible. As part of the Financing Agreement, on May 27, 2003 we issued to Silicon Valley Bank (SVB) warrants to purchase up to 165,000 shares of NaviSite common stock with an exercise price of $2.50, the closing price of our stock on the last business day before the issuance of the warrant. We fair valued the warrants at $370,000 using the Black-Scholes option-pricing model. The value of the warrants is being amortized into interest expense over the term of the Financing Agreement. At July 31, 2003, we had $6.7 million outstanding under the Financing Agreement, which represented the maximum borrowings under the Financing Agreement at that time.

     (c)     Note Payable to Atlantic Investors, LLC (Atlantic)

      On January 29, 2003, we entered into a $10.0 million Loan and Security Agreement (Atlantic Loan) with Atlantic, a related party. The Atlantic Loan has a termination date of February 1, 2004 and bears an interest rate of 8% per annum. Interest is payable upon demand or, at Atlantic’s option, interest may be added to the outstanding balance due to Atlantic by NaviSite. Atlantic may make demand for payment of amounts excess of the minimum Atlantic Loan amount of $2.0 million (Minimum Loan Amount), with 60 days notice, but not such that the payment would be required before February 1, 2004. Atlantic can demand payment of the Minimum Loan Amount with 90 days notice, but not such that payment would be required before August 1, 2003. Under the Atlantic Loan agreement, we can require Atlantic to loan us (1) up to $2.0 million to repay an amount due from CBTM to Unicorn, a related party to NaviSite and Atlantic; (2) $1.0 million for costs associated with our acquisition of Avasta; and (3) up to $500,000 for the post-acquisition working capital needs of Avasta, Atlantic, at its sole and absolute discretion, may advance other amounts to us such that the aggregate amount borrowed by NaviSite does not exceed the maximum loan amount, defined as the lesser of $10.0 million or 65% of our consolidated accounts receivables. On May 30, 2003 we repaid $2.0 million of the approximate $3.0 million outstanding under the Atlantic Loan and on June 11, 2003, we borrowed $2.0 million under the Atlantic Loan. At July 31,

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

2003, we had $3.0 million outstanding under the Atlantic Loan. This amount is shown as Current Note Payable to Related Party on our Consolidated Balance Sheet. The Atlantic Loan is secured by all of our receivables.

     (d)     Note Payable to the AppliedTheory Estate

      As part of CBTM’s acquisition of certain AppliedTheory assets, CBTM entered into a long-term liability of $6.0 million (Estate Liability) due to the AppliedTheory Estate in June 10, 2006. The Estate Liability bears interest at 8% per annum, which is due and payable at the termination date of the Estate Liability. At July 31, 2003, we had approximately $80,000 in accrued interest related to this note.

     (e)     Notes Payable to the Interliant Estate

      As part of our acquisition of certain Interliant Assets, we entered into a promissory note with the Interliant Estate (Interliant Promissory Note) in the amount of $550,000, payable without interest on the earlier of (i) the 180th day following the Second Closing Date or (ii) the date Interliant estates make distributions to their general unsecured creditors. The Interliant Promissory Note is secured by the Interliant Notes (see Note 6).

(10)     Commitments and Contingencies

     (a)     Leases

      Abandoned Leased Facilities. On January 31, 2003, we abandoned our administrative space on the second floor of our 400 Minuteman Road, Andover, MA leased location. We continue to maintain and operate our Data Center on the first floor of the building, which also serves as our corporate headquarters. While we remain obligated under the terms of the lease for the rent and other costs associated with the second floor of the building, we ceased to use the space on January 31, 2003 and have no foreseeable plans to occupy the second floor in the future. Therefore, in accordance with SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities,” issued in July 2002, we recorded a charge to our current earnings in fiscal year 2003 of approximately $5.4 million to recognize the costs of exiting the space. The amount is included in the caption “Impairment and restructuring” in the accompanying Consolidated Statements of Operations. The liability is equal to the total amount of rent and other direct costs for the period of time the second floor of the building was expected to remain unoccupied plus the present value of the amount by which the rent paid by us to the landlord exceeds any rent paid to us by a tenant under a sublease over the remainder of the lease term, which is May 2011.

      Near the end of our fiscal year 2002, we abandoned our sales office space in La Jolla, CA. At that time we were able to sublet the space to a third party. During the second quarter of fiscal year 2003, the sublease tenant stopped making payments under the sublease and has abandoned the space. The facility is currently empty and we remain obligated under the terms of the lease for the rent and other costs associated with the building. We have no foreseeable plans to occupy the space, therefore, under SFAS 146, we recorded a charge to our earnings of approximately $1.4 million to recognize the costs of exiting the building. The amount is included in the caption “Impairment and restructuring” in the accompanying Consolidated Statements of Operations. We are actively pursuing options for subleasing or otherwise terminating the lease, but have not reached any agreement at this time. We believe it is more likely than not that we will be able to sublet the building to a tenant at, at a rate below our current rent rate or will have otherwise ended the lease via a lease termination agreement, by January 2004. As such, we have recorded a liability equal to the present value of our estimated future payments.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      Details of activity in the lease exit accrual for the year ended July 31, 2003 were as follows:

                                         
Balance at Balance at
July 31, 2002 Expense Payments Adjustments July 31, 2003





(In thousands)
400 Minuteman lease abandonment costs
  $     $ 5,409     $ (2,069 )   $     $ 3,340  
La Jolla lease abandonment costs
          1,431       (322 )           1,109  
Chicago and Virginia lease abandonment costs
                (301 )     1,700 (1)     1,399  
Amsterdam lease abandonment costs
                      164 (1)     164  
     
     
     
     
     
 
    $     $ 6,840     $ (2,692 )   $ 1,864     $ 6,012 (2)
     
     
     
     
     
 


(1)  Recorded in purchase accounting for the acquisition of Conxion Corporation
 
(2)  The current portion of the balance of $2.5 million is included in accrued expenses (Note 8)

      We are obligated under various capital and operating leases for facilities and equipment. CMGI had entered into non-cancelable operating and capital leases on our behalf covering certain of our office facilities and equipment, which expire through 2012. In addition, until we moved our headquarters in January 2000, we paid CMGI for office facilities used as our headquarters for which we were charged based upon an allocation of the total costs for the facilities at market rates. Prior to our IPO, substantially all leases for real property were guaranteed by CMGI. CMGI charged us the actual lease fees under these arrangements. Our total rent expense amounted to $10.2 million, $19.6 million, and $58.5 million for the fiscal years ended July 31, 2003, 2002, and 2001, respectively. In June 2000, we sold certain equipment and leasehold improvements in our data centers in a sale-leaseback transaction to a bank for approximately $30.0 million. We entered into a capital lease for the leaseback of those assets. In January 2001, we paid-off these capital lease obligations for approximately $27.0 million. During the second quarter of fiscal year 2001, we sold certain equipment in sale-leaseback transactions for a total of approximately $13.9 million. Simultaneously with the sales, we entered into operating leases for the equipment.

      During fiscal 2002, we renegotiated or bought out the majority of the operating lease obligations for equipment.

      Minimum annual rental commitments under operating leases and other commitments are as follows as of July 31, 2003:

                                         
Less than After 5
Description Total 1 Year 1-3 Years 4-5 Years Years






(In thousands)
Short/ Long-term debt
  $ 10,211     $ 4,211     $ 6,000     $     $  
Interest on debt
    1,610       650       960              
Capital leases
    5,175       3,273       1,902              
Operating leases
    1,336       1,008       328              
Bandwidth commitments
    6,717       3,542       2,384       791        
Maintenance for hardware/software
    1,405       1,405                    
Property leases
    87,155       13,357       25,306       19,169       29,323  
     
     
     
     
     
 
    $ 113,609     $ 27,446     $ 36,880     $ 19,960     $ 29,323  
     
     
     
     
     
 

      With respect to the property lease commitments listed above, certain cash is restricted pursuant to terms of lease agreements with landlords. At July 31, 2003, this restricted cash of $3,054,000 on the

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

balance sheet consisted of certificates of deposit at one major financial institution and are recorded at cost, which approximates fair value.

     (b)     Legal Matters

      On or about June 13, 2001, Stuart Werman and Lynn McFarlane filed a lawsuit against us, BancBoston Robertson Stephens, an underwriter of our initial public offering in October 1999, Joel B. Rosen, our then chief executive officer, and Kenneth W. Hale, our then chief financial officer. The suit was filed in the United States District Court for the Southern District of New York. The suit generally alleges that the defendants violated federal securities laws by not disclosing certain actions allegedly taken by Robertson Stephens in connection with our initial public offering. The suit alleges specifically that Robertson Stephens, in exchange for the allocation to its customers of shares of our common stock sold in our initial public offering, solicited and received from its customers’ agreements to purchase additional shares of our common stock in the aftermarket at pre-determined prices. The suit seeks unspecified monetary damages and certification of a plaintiff class consisting of all persons who acquired shares of our common stock between October 22, 1999 and December 6, 2000. Three other substantially similar lawsuits were filed between June 15, 2001 and July 10, 2001 by Moses Mayer (filed June 15, 2001), Barry Feldman (filed June 19, 2001), and Binh Nguyen (filed July 10, 2001). Robert E. Eisenberg, our president at the time of the initial public offering in 1999, also was named as a defendant in the Nguyen lawsuit.

      On or about June 21, 2001, David Federico filed in the United States District Court for the Southern District of New York a lawsuit against us, Mr. Rosen, Mr. Hale, Robertson Stephens and other underwriter defendants including J.P. Morgan Chase, First Albany Companies, Inc., Bank of America Securities, LLC, Bear Stearns & Co., Inc., B.T. Alex. Brown, Inc., Chase Securities, Inc., CIBC World Markets, Credit Suisse First Boston Corp., Dain Rauscher, Inc., Deutsche Bank Securities, Inc., The Goldman Sachs Group, Inc., J.P. Morgan & Co., J.P. Morgan Securities, Lehman Brothers, Inc., Merrill Lynch, Pierce, Fenner & Smith, Inc., Morgan Stanley Dean Witter & Co., Robert Fleming, Inc. and Salomon Smith Barney, Inc. The suit generally alleges that the defendants violated the anti-trust laws and the federal securities laws by conspiring and agreeing to raise and increase the compensation received by the underwriter defendants by requiring those who received allocation of initial public offering stock to agree to purchase shares of manipulated securities in the after-market of the initial public offering at escalating price levels designed to inflate the price of the manipulated stock, thus artificially creating an appearance of demand and high prices for that stock, and initial public offering stock in general, leading to further stock offerings. The suit also alleges that the defendants arranged for the underwriter defendants to receive undisclosed and excessive brokerage commissions and that, as a consequence, the underwriter defendants successfully increased investor interest in the manipulated initial public offering of securities and increased the underwriter defendants’ individual and collective underwritings, compensation, and revenues. The suit further alleges that the defendants violated the federal securities laws by issuing and selling securities pursuant to the initial public offering without disclosing to investors that the underwriter defendants in the offering, including the lead underwriters, had solicited and received excessive and undisclosed commissions from certain investors. The suit seeks unspecified monetary damages and certification of a plaintiff class consisting of all persons who acquired shares of our common stock between October 22, 1999 and June 12, 2001.

      Those five cases, along with lawsuits naming more than 300 other issuers and over 50 investment banks which have been sued in substantially similar lawsuits, have been assigned to the Honorable Shira A. Scheindlin (the “Court”) for all pretrial purposes (the “IPO Securities Litigation”). On September 6, 2001, the Court entered an order consolidating the five individual cases involving us and designating Werman v. NaviSite, Inc., et al., Civil Action No. 01-CV-5374 as the lead case. A consolidated, amended complaint was filed thereafter on April 19, 2002 (the “Class Action Litigation”) on behalf of plaintiffs

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Arvid Brandstrom and Tony Tse against underwriter defendants Robertson Stephens (as successor-in-interest to BancBoston), BancBoston, J.P. Morgan (as successor-in-interest to Hambrecht & Quist), Hambrecht & Quist and First Albany and against us and Messrs. Rosen, Hale and Eisenberg (collectively, the “NaviSite Defendants”). Plaintiffs uniformly allege that all defendants, including the NaviSite Defendants, violated the federal securities laws (i.e., Sections 11 and 15 of the Securities Act, Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5) by issuing and selling our common stock pursuant to the October 22, 1999, initial public offering, without disclosing to investors that some of the underwriters of the offering, including the lead underwriters, had solicited and received extensive and undisclosed agreements from certain investors to purchase aftermarket shares at pre-arranged, escalating prices and also to receive additional commissions and/or other compensation from those investors. At this time, plaintiffs have not specified the amount of damages they are seeking in the Class Action Litigation.

      Between July and September 2002, the parties to the IPO Securities Litigation briefed motions to dismiss filed by the underwriter defendants and the issuer defendants, including NaviSite. On November 1, 2002, the Court held oral argument on the motions to dismiss. The plaintiffs have since agreed to dismiss the claims against Messrs. Rosen, Hale and Eisenberg without prejudice, in return for their agreement to toll any statute of limitations applicable to those claims. By stipulation entered by the Court on November 18, 2002, Messrs. Rosen, Hale and Eisenberg were dismissed without prejudice from the Class Action Litigation. On February 19, 2003, an opinion and order was issued on defendants’ motion to dismiss the IPO Securities Litigation, essentially denying the motions to dismiss of all 55 underwriter defendants and of 185 of the 301 issuer defendants.

      We believe that the allegations against us are without merit and we intend to vigorously defend against the plaintiffs’ claims. We are not able to predict the possible outcome of the suits and their ultimate effect, if any, on our financial condition.

      In March 2001, we engaged Goldman Sachs & Co. to serve as our financial advisor in connection with the possible sale of all or a portion of NaviSite. On September 17, 2002, Goldman made a written demand for payment of a $3 million success fee in connection with the September 2002 acquisition by ClearBlue of the stock and convertible debt of NaviSite from CMGI and Hewlett-Packard Financial Services Company. We have rejected Goldman’s demands, as we believe they are without merit. No legal actions have been filed concerning the Goldman claim. As this matter is in the initial stage, we are not able to predict the possible outcome of this matter and the effect, if any, on our financial condition.

      On or about September 27, 2002, we received a demand for a wage payment of $850,000 from our former Procurement Director, Joseph Cloonan. We rejected the demand, alleging that Mr. Cloonan’s claim is based, among other things, on a potentially fraudulent contract. Mr. Cloonan also claimed $40,300 for allegedly unpaid accrued vacation and bonuses and that he may be statutorily entitled to treble damages and legal fees. On October 11, 2002, NaviSite filed a civil complaint with the Massachusetts Superior Court, Essex County, seeking a declaratory judgment and asserting claims against Mr. Cloonan for civil fraud, misrepresentation, unjust enrichment and breach of duty of loyalty. We believe the allegations are without merit and intend to vigorously defend against Mr. Cloonan’s claims. As the litigation is in the initial discovery stage, we are not able to predict the possible outcome of this matter and the effect, if any, on our financial condition.

      On October 28, 2002, ClearBlue Technologies Management, Inc., one of our subsidiaries, filed a complaint in United States District Court for the Southern District of New York against Lighthouse International, alleging six causes of action for copyright infringement, breach of contract, account stated, unjust enrichment, unfair competition, and misappropriation and/or conversion. The total claimed damages are in the amount of $1.9 million. On or about January 16, 2003, Lighthouse filed and served its answer and counterclaimed against ClearBlue Technologies Management, Inc. claiming $3.1 million in damages and $5.0 million in punitive relief.

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      On June 17, 2003, the U.S. Bankruptcy Court for the Southern District of New York heard oral argument on Lighthouse’s Motion for an Order Compelling the Debtor (AppliedTheory) to Assume or Reject an Agreement, filed in response to ClearBlue Technologies Management, Inc.’s. complaint, and the objections to Lighthouse’s motion filed by ClearBlue Technologies Management and AppliedTheory. Lighthouse made this motion on the basis that it never received notice of ClearBlue Technologies Management assuming the AppliedTheory contract for the LighthouseLink Web site. The Bankruptcy Court declined to grant Lighthouse’s motion, and instead ordered that an evidentiary hearing be conducted to determine whether Lighthouse received appropriate notice of the proposed assignment of the contract by AppliedTheory to ClearBlue Technologies Management. The Bankruptcy Court ordered that the parties first conduct discovery, and upon completion of discovery, which is expected to be completed on or about the end of November 2003, the Bankruptcy Court would schedule an evidentiary hearing on the issue of notice.

      As to the U.S. District Court matter, the exchange of written discovery is near completion, with a number of discovery disputes to be resolved by the Court in October 2003 at a discovery status conference. All depositions of witnesses have been stayed pending completion of the Bankruptcy Court evidentiary hearing. Because of the continuing discovery, and the uncertain outcome of the evidentiary hearing before the Bankruptcy Court, we are not able to predict the possible outcome of this matter, if any, on our financial condition.

      On December 12, 2002, our Board of Directors, pursuant to authority previously granted by our stockholders at the annual meeting of stockholders held on December 19, 2001, approved a reverse stock split of our common stock at a ratio of one-for-fifteen (1:15) (the “Reverse Split”). The Reverse Split was effective on January 7, 2003. On May 28, 2003 we received a letter from Mr. Edward W. Roberts, as trustee of The Roberts Family Trust, stating that in June 2002 the trust had purchased 13,000 shares of our common stock and due to the Reverse Split, the trust now owns 866 shares of common stock (i.e. 13,000 shares divided by 15). As a result of the Reverse Split, Mr. Roberts states an intention to institute a derivative action requesting $7.5 million in damages. On October 20, 2003, we received a letter dated October 13, 2003, from Mr. Robertson, as trustee on behalf of The Roberts Family Trust, stating his intention to prove conspiracy and collusion relating to the September 11, 2002 transactions between ClearBlue Technologies, Inc. and Hewlett-Packard Financial Services Company and relating to the later Reverse Split. No legal actions have been filed concerning this matter. This matter is in its initial stages and we are not able to predict the possible outcome of this matter, and the effect, if any, on our financial condition. We believe the claim is without merit and intend to vigorously defend any action that may be brought against us.

      On October 14, 2003, we received a letter purportedly on behalf of the former stockholders of Avasta relating to the issuance of additional shares of common stock pursuant to the earnout calculations pursuant to the Agreement and Plan of Merger and Reorganization dated as of January 29, 2003 among Avasta Corp., Avasta, Inc. and NaviSite. No legal actions have been filed concerning this matter. As this matter is in the initial stage, we are not able to predict the possible outcome of this matter and the effect, if any, on our financial condition.

      We are also subject to other legal proceedings and claims which arise in the ordinary course of our business. In the opinion of management, the amount of ultimate liability with respect to these actions will not materially affect our consolidated financial position or results from our operations.

(11)     Income Taxes

      Prior to the initial public offering on October 21, 1999, we were greater than 80% owned by CMGI, and as such, CMGI realized the full benefit of all federal and part of the state net operating losses that had been incurred by us for those periods before the fiscal year ended July 31, 2001. Therefore, such net

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

operating losses incurred by NaviSite were not available to us. The tax sharing agreement between NaviSite and CMGI required us to reimburse CMGI for the amounts it contributed to the consolidated tax liability of the CMGI group; however, under the policy, CMGI was not obligated to reimburse us for any losses utilized in the consolidated CMGI group. After our public offering, CMGI’s ownership fell below 80% and we were no longer included in the federal consolidated group of CMGI. Thus, our federal and state net operating losses can be carried forward to offset our future taxable income.

      Total federal and state income tax expenses (benefit) for the periods ending July 31, 2003, July 31, 2002, and July 31, 2001, consist of the following:

                                                                         
7/31/2003 7/31/2002 7/31/2001



Current Deferred Total Current Deferred Total Current Deferred Total









(In thousands)
Federal
  $ (513 )   $ 513     $     $     $     $     $     $     $  
State
    153             153                                      
     
     
     
     
     
     
     
     
     
 
    $ (360 )   $ 513     $ 153     $     $     $     $     $     $  
     
     
     
     
     
     
     
     
     
 

      The actual tax expense for the periods ending July 31, 2003, July 31, 2002, and July 31, 2001, differs from the expected tax expense for the these periods as follows:

                         
7/31/2003 7/31/2002 7/31/2001



(In thousands)
Computed “expected” tax expense (benefit)
  $ (24,981 )   $ (41,376 )   $ (40,358 )
State taxes, net of federal income tax benefit
    101              
Losses not benefited
    25,033       41,376       40,358  
     
     
     
 
Total
  $ 153     $     $  
     
     
     
 

      Temporary differences between the financial statement carrying and tax bases of assets and liabilities that give rise to significant portions of deferred tax assets (liabilities) are comprised of the following:

                 
7/31/03 7/31/02


(In thousands)
Deferred tax assets:
               
Accruals and reserves
  $ 4,455     $ 2,206  
Loss Carryforwards
    20,709       103,311  
Depreciation and amortization
    33,134       36,958  
     
     
 
Total deferred tax assets
  $ 58,298     $ 142,475  
Less: Valuation allowance
    (58,298 )     (142,475 )
     
     
 
Net deferred tax (assets) liabilities
  $     $  
     
     
 

      Valuation allowance decreased by $84.2 million and increased by $47.0 million for the years ended July 31, 2003 and 2002, respectively. The Company has recorded a full valuation allowance against its deferred tax assets since management believes that, after considering all the available objective evidence, both positive and negative, historical and prospective, with greater weight given to historical evidence, it is not more likely than not that these assets will be realized.

      As a result of the transaction on September 11, 2002, the Company experienced a change in ownership as defined in Section 382 of the Internal Revenue Code. As a result of the change in ownership, the utilization of its federal and state tax net operating losses generated prior to the transaction is subject

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

to an annual limitation of approximately $1.2 million. As a result of this limitation, the Company expects that a substantial portion its federal and state net operating loss carryforwards will expire unused.

      The company has net operating loss carryforwards for federal and state tax purposes of approximately $50.2 million, after taking into consideration net operating losses expected to expire unused due to the Section 382 limitation. The federal net operating loss carryforwards will expire from fiscal year 2011 to fiscal year 2023.

(12)     Stockholders’ Equity

     (a)     Issuance of Common Stock

      On December 12, 2002, ClearBlue cancelled warrants to purchase 346,883 shares of our common stock at an exercise price ranging from $86.55 to $103.80 per share.

      The 567,978 shares issued to ClearBlue on December 31, 2002 in connection with the acquisition of CBTM have been accounted for by us as a dividend distribution to ClearBlue because ClearBlue and its affiliates are considered to have controlling interest over both CBTM and NaviSite. As a result, we reported a reduction of retained earnings of $1.3 million, which represents the number of common shares issued at the then current market value of $2.25 per share.

      On February 5, 2003, we issued 231,039 shares of our common stock at a per share value of $1.60 in connection with the acquisition of Avasta (see Note 6). In September 2003 we issued 179,353 shares of our common stock at a per share value of $4.14 (representing the market value of our common stock the day preceding the issuance of the addition shares) for the attainment of certain revenue targets in conjunction with the Avasta acquisition.

(13)     Stock Option Plans

     (a)     1999 Employee Stock Purchase Plan

      The 1999 Employee Stock Purchase Plan (the Stock Purchase Plan) was adopted by NaviSite’s board of directors and stockholders in October 1999. The Stock Purchase Plan provides for the issuance of a maximum of 16,666 shares of our common stock. The Plan allows participants to purchase shares at 85% of the closing price of common stock on the first business day of the Plan period or the last business day of the Plan period, whichever closing price is less. During fiscal year 2002, no additional shares were issued under this plan.

      During fiscal year 2003, no additional shares were issued under this plan. We issued a total of 16,657 shares since the plan’s inception.

     (b)     Deferred Compensation Plan

      A Deferred Compensation Plan (the Deferred Compensation Plan) was adopted by NaviSite’s board of directors in October 1999. Under the terms of the Deferred Compensation Plan, our employees who are selected by the board of directors (as well as certain of our employees who previously participated in a deferred compensation plan sponsored by CMGI) will be able to elect to defer a portion of their compensation for the following calendar year. We also may make discretionary contributions to a participant’s account, to which the participant generally will become entitled after five years of service with us. Effective December 18, 2001, the plan was terminated. During 2001 and through the termination date in 2002, we did not make any discretionary contributions to the plan.

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     (c)     1999 Director Stock Option Plan

      In October 1999, NaviSite ceased issuing options under the 1998 Director Plan and the board of directors and the stockholders approved and adopted the 1999 Stock Option Plan for Non-employee Directors (the 1999 Director Plan). A total of 33,333 shares of Common Stock are reserved for issuance under the 1999 Director Plan. Directors who are not NaviSite employees or otherwise affiliates, employees or designees of an institutional or corporate investor that owns more than 5% of outstanding Common Stock will be eligible to receive non-statutory stock options under the 1999 Director Plan. On March 5, 2002, the 1999 Director Plan was amended to increase the initial options granted to each eligible director to 3,333 shares from the original 1,667 shares and to increase the subsequent annual grants to directors to 667 shares from the original 417 shares.

      The board of directors has discretion to increase to up to 6,667 shares the number of shares of Common Stock subject to any initial option or additional option covering any vesting period of up to 48 months that may be granted to an eligible director after the date of the increase.

      During fiscal year 2003 no options were granted and there were no outstanding options under this plan. Upon the approval of the 2003 Plan by NaviSite’s stockholders, no further option grants shall be made under the 1999 Director Plan.

     (d)     1998 Director Stock Option Plan

      In December 1998, NaviSite’s board of directors and stockholders approved the 1998 Director Stock Option Plan (the 1998 Director Plan). In October 1999, we ceased issuing options under the 1998 Director Plan. Upon the adoption of the 1999 Director Plan, each NaviSite director (who is not also an employee of NaviSite, any subsidiary of NaviSite or of CMGI) was entitled to receive, upon the date of his or her election, a non-statutory option to purchase Common Stock as defined. A maximum number of 16,666 shares of Common Stock were authorized for issuance under the 1998 Director Plan. Each automatic grant had an exercise price equal to the current fair market value of the Common Stock at the time of grant and a maximum term of ten years, subject to earlier termination following the optionee’s cessation of service on the board of directors.

      During fiscal 2003, no options were granted and no options were outstanding under the 1998 Director Plan.

     (e)     NaviSite 2000 Stock Option Plan

      In November 2000, NaviSite’s board of directors approved the 2000 Stock Option Plan (the Plan). Under the Plan, nonqualified stock options or incentive stock options may be granted to NaviSite’s employees, other than those who are also officers or directors, and our consultants and advisors, as defined, up to a maximum number of shares of Common Stock not to exceed 66,666 shares. The board of directors administers this plan, selects the individuals who are eligible to be granted options under the Plan and determines the number of shares and exercise price of each option. Options granted under the Plan have a five-year maximum term and typically vest over a one-year period. Upon the approval of the 2003 Plan by

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NaviSite’s stockholders, no further option grants shall be made under the Plan. The following table reflects activity of stock options under our Plan for the year ended July 31, 2003:

                                                 
2003 2002 2001



Weighted Weighted Weighted
Number Average Number Average Number Average
of Exercise of Exercise of Exercise
Shares Price Shares Price Shares Price






Options outstanding beginning of year
    16,266     $ 128.44       32,157     $ 128.44           $  
Granted
                            53,037       128.44  
Exercised
                                   
Cancelled
    (11,394 )     128.44       (15,891 )     128.44       (20,880 )     128.44  
     
     
     
     
     
     
 
Options outstanding, end of year
    4,872     $ 128.44       16,266     $ 128.44       32,157     $ 128.44  
     
     
     
     
     
     
 
Options exercisable, end of year
    4,872               16,266                        
     
             
             
         
Options available for grant, end of year
    61,794               50,400               34,509          
     
             
             
         

     (f)     NaviSite 1998 Equity Incentive Plan

      In December 1998, NaviSite’s board of directors and stockholders approved the 1998 Equity Incentive Plan, as amended (the 1998 Plan). The 1998 Plan replaced NaviSite Internet Services Corporation’s 1997 Equity Incentive Plan (the 1997 Plan). All options outstanding under the 1997 Plan were cancelled and replaced with an equivalent amount of options issued in accordance with the 1998 Plan. Under the original 1998 Plan, nonqualified stock options or incentive stock options may be granted to NaviSite’s or its affiliates’ employees, directors, and consultants, as defined, up to a maximum number of shares of Common Stock not to exceed 333,333 shares. In August 1999, the board of directors approved an increase in the number of shares authorized under the 1998 Plan to 741,628. In December 2000, the board of directors approved an additional increase in the number of shares authorized under the 1998 Plan to 1,000,000 shares. The board of directors administers this plan, selects the individuals who are eligible to be granted options under the 1998 Plan and determines the number of shares and exercise price of each option. The chief executive officer, upon authority granted by the board of directors, is authorized to approve the grant of options to purchase Common Stock under the 1998 Plan to certain persons. Options are granted at fair market value. Options granted under the 1998 Plan have a five-year maximum term and typically vest over a four year period, with 25% of options granted becoming exercisable one year from the date of grant and the remaining 75% vesting monthly for the next thirty-six (36) months. Upon the approval of the 2003 Plan by NaviSite’s stockholders, no further option grants shall be made under the

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1998 Plan. The following table reflects activity and historical exercise prices of stock options under our 1998 Plan for the three years ended July 31, 2003.

                                                 
2003 2002 2001



Weighted Weighted Weighted
Number Average Number Average Number Average
of Exercise of Exercise of Exercise
Shares Price Shares Price Shares Price






Options outstanding beginning of year
    452,801     $ 149.40       522,560     $ 276.00       534,262     $ 416.85  
Granted
    128,164       2.57       268,397       4.65       427,638       100.20  
Exercised
    (1,905 )     1.18       (34,901 )     1.05       (35,153 )     9.00  
Cancelled
    (313,091 )     160.79       (303,255 )     256.35       (404,187 )     297.60  
     
     
     
     
     
     
 
Options outstanding, end of year
    265,969     $ 66.14       452,801     $ 149.40       522,560     $ 276.00  
     
     
     
     
     
     
 
Options exercisable, end of year
    175,555     $ 84.18       131,156     $ 294.60       198,472     $ 266.85  
     
     
     
     
     
     
 
Options available for grant, end of year
    571,661               386,606               351,781          
     
             
             
         
                                             
Options Outstanding

Options Exercisable
Weighted
Average Weighted Weighted
Remaining Average Average
Number Contractual Exercise Number Exercise
Range of Exercise Prices Outstanding Life (Years) Price Outstanding Price






$    .01 – $  2.40       6,413       1.12     $ 0.90       5,214     $ 0.58  
     2.41 –    2.55       120,000       9.94       2.55       60,000       2.55  
     2.56 –    3.90       42,511       3.64       3.90       22,771       3.90  
     3.91 –    9.60       37,157       3.30       4.87       36,948       4.86  
     9.61 –   27.75       29,153       22.39       2.68       24,610       23.32  
    27.76 –   73.13       5,042       2.04       51.16       3,839       51.52  
    73.14 –  182.82       7,160       1.31       113.02       6,537       110.86  
   182.83 –  671.25       7,054       1.82       620.52       5,504       618.92  
   671.26 up       11,479       1.53       943.99       10,132       932.79  
         
                     
         
          265,969                       175,555          
         
                     
         

     (g)     NaviSite 2003 Stock Option Plan

      On July 10, 2003, the 2003 Stock Incentive Plan (the “2003 Plan”) was approved by the Board of Directors. The 2003 Plan has not yet been approved by NaviSite’s Stockholders. The 2003 Plan provides that stock options or restricted stock awards may be granted to employees, officers, directors, consultants, and advisors or NaviSite (or any present or future parent or subsidiary corporations and any other business venture (including, without limitation, joint venture or limited liability company) in which NaviSite has a controlling interest, as determined by the Board of Directors of NaviSite) The board of directors has authorized 2,600,000 shares of common stock for issuance under the 2003 Plan.

      The 2003 Plan is administered by the Board of Directors of NaviSite or any committee to which the Board delegates its powers under the 2003 Plan. Subject to the provisions of the 2003 Plan, the Board of Directors will determine the terms of each award, including the number of shares of common stock subject to the award and the exercise thereof.

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NAVISITE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      The Board of Directors may, in its sole discretion, amend, modify or terminate any award granted or made under the 2003 Plan, so long as such amendment, modification or termination would not materially and adversely affect the participant. The Board of Directors may also provide that any stock option shall become immediately exercisable, in full or in part, or that any restricted stock granted under the 2003 Plan shall be free of some or all restrictions.

      As of July 31, 2003, stock options to purchase 2,272,000 shares of common stock at an average exercise price of $2.55 per share were outstanding under the 2003 Plan. During fiscal year 2003, no options were exercised or cancelled. The options do not become exercisable until the stockholders of the Company have duly approved the plan. Once approved, the options will become exercisable as to 25% of the original number of shares on grant date and thereafter in equal amounts monthly over the three year period commencing on the grant date.

     (h)     CMGI 1986 Stock Option Plan

      Certain NaviSite employees have been granted options for the purchase of CMGI Common Stock under the CMGI 1986 Stock Option Plan (the 1986 Plan). Options under the 1986 Plan are granted at fair market value on the date of grant and are generally exercisable in equal cumulative installments over a four-to-ten year period beginning one year after the date of grant. Outstanding options under the 1986 Plan expire through 2007. Under the 1986 Plan, nonqualified stock options or incentive stock options may be granted to CMGI’s or its subsidiaries’ employees, as defined. The board of directors of CMGI administers this plan, selects the individuals to whom options will be granted and determines the number of shares and exercise price of each option.

      The following table reflects activity and historical exercise prices of stock options granted to NaviSite employees under the 1986 Plan for the three years ended July 31, 2003. Options held by employees who transferred to NaviSite from CMGI or CMGI subsidiaries kept their CMGI options and during fiscal year 2003, 2002 and 2001 are shown as transfers into the 1986 plan. Employees that transferred to CMGI from an affiliate could not keep their affiliate options.

      On September 11, 2002 each of CMGI and Hewlett-Packard Financial Services Company (HPFS) sold and transferred to ClearBlue Technologies, Inc. (ClearBlue), a privately-held managed service provider based in San Francisco, California equity and debt interests. Due to this transaction, NaviSite employees had 30 days from September 11, 2002 to exercise vested CMGI options. There were no options exercised and subsequently all outstanding options were cancelled.

      The following table summarizes information about stock options granted NaviSite employees under the 1986 Plan outstanding at July 31, 2003:

                                                 
2003 2002 2001



Weighted Weighted Weighted
Number Average Number Average Number Average
of Exercise of Exercise of Exercise
Shares Price Shares Price Shares Price






Options outstanding beginning of year
    106,582     $ 8.76       349,562     $ 26.10       510,923     $ 27.85  
Granted
                                   
Transfers
                (2,834 )     20.26       14,615       24.40  
Exercised
                            (48,803 )     4.72  
Cancelled
    (106,582 )     8.76       (240,146 )     32.44       (127,173 )     44.60  
     
     
     
     
     
     
 
Options outstanding, end of year
        $       106,582     $ 8.76       349,562     $ 26.10  
     
     
     
     
     
     
 
Options exercisable, end of year
                  97,486     $ 7.86       261,090     $ 31.39  
     
             
     
     
     
 

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NAVISITE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
(i)     Other Stock Option Grants

      At July 31, 2003, we had 2,665 outstanding stock options issued outside of existing plans to certain directors at an average exercise price of $135.56. These stock options were fully vested on the grant date and have a contractual life of 10 years.

 
(j)     Other Disclosure

      SFAS No. 123, Accounting for Stock-Based Compensation (SFAS 123), sets forth a fair-value based method of recognizing stock-based compensation expense. As permitted by SFAS No. 123, we have elected to continue to apply APB No. 25 to account for the stock-based compensation plans in which NaviSite’s employees participate.

(14)     Related Party Transactions

      For the period August 1, 2002 through September 11, 2002, we classified revenue from CMGI and CMGI affiliates as revenue from related parties. For the period September 12, 2002 through July 31, 2003, we classified revenue from CMGI and CMGI affiliates as third-party revenue.

      The consolidated financial statements include certain allocations from CMGI for certain general and administrative expenses, such as rent, legal services, insurance, and employee benefits. Allocations are based primarily on headcount. Management believes that the method used to allocate the costs and expenses is reasonable; however, such allocated amounts may or may not necessarily be indicative of what actual expenses would have been incurred had we operated independently of CMGI. As a result of CMGI’s sale of its debt and equity interests in us, the agreement between NaviSite and CMGI whereby CMGI provided certain services for us automatically terminated. CMGI continued to provide certain services to us pursuant to a Transition Services Agreement we entered into with CMGI on November 25, 2002, as we transitioned to services agreements with ClearBlue and to other third-party suppliers. This transition agreement concluded during the second quarter of fiscal year 2003 and we have completely severed our administrative ties with CMGI; however, CMGI remains a third-party customer. During the second quarter of fiscal year 2003, we contracted with ClearBlue and third-party suppliers for these services. We currently rent administrative facilities from CMGI at 800 Federal Street, Andover, Massachusetts.

      On December 31, 2002, CBTM was required to pay a $6.1 million liability owed to the AppliedTheory Estate as a result of CBTM’s acquisition of AppliedTheory. In order to fund the $6.1 million payment, CBTM entered into a $6.0 million line of credit with Unicorn Worldwide Holding Limited (Unicorn), a related party to NaviSite and CBTM. CBTM drew down $4.6 million and together with cash on hand at December 31, 2002, paid the $6.1 million liability due to the AppliedTheory Estate. In January 2003, CBTM paid $2.6 million of the $4.6 million due to Unicorn, leaving a liability to Unicorn of $2.0 million at January 31, 2003. In January 2003, we entered into a Loan and Security Agreement with Atlantic and in February 2003, drew down on this facility to pay off the remaining $2.0 million due Unicorn by CBTM. CBTM has a long-term liability of $6.0 million (Estate Liability) due to the AppliedTheory Estate in June 10, 2006. The Estate Liability bears interest at 8% per annum, which is due and payable at the termination date of the Estate Liability.

      Beginning January 1, 2003, we entered into an Outsourcing Agreement with ClearBlue whereby we provided certain management services as well as manage the day-to-day operations of ClearBlue’s data centers. We charge ClearBlue actual costs incurred plus a 5% mark-up on labor costs only. In fiscal year 2003, we charged ClearBlue approximately $270,000 under this agreement. This amount is included in other income in the Consolidated Statement of Operations. In connection with the Outsourcing Agreement, we entered into two loan arrangements, one whereby we will loan amounts to ClearBlue for

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NAVISITE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

working capital needs (NaviSite Loan) and one whereby ClearBlue will loan amounts to NaviSite for working capital needs (ClearBlue Loan). The two loans may be drawn down upon, at the sole discretion of the lender, up to a maximum aggregate amount of $2.0 million per note. ClearBlue owed us approximately $1.9 million at April 30, 2003 under the NaviSite Loan. In addition to the amount due under the NaviSite loan, ClearBlue owed certain amounts to CBTM at the time of CBTM’s sale to NaviSite. On June 2, 2003, we amended the NaviSite Loan to increase the borrowing facility, on a temporary basis, to $2.3 million and loaned an additional $200,000 to ClearBlue. The additional $200,000 funding to ClearBlue was repaid to us on June 6, 2003. On June 16, 2003, we used $3.9 million of the amounts due to us by ClearBlue to pay down a portion of our $45.0 million outstanding on the New Note.

      On January 29, 2003, we entered into a $10 million Loan and Security Agreement (Atlantic Loan) with Atlantic, a related party. The Atlantic Loan has a termination date of February 1, 2004 and bears an interest rate of 8% per annum. Interest is payable upon demand or, at Atlantic’s option, interest may be added to the outstanding balance due to Atlantic by NaviSite. Atlantic may make demand for payment of amounts in excess of the minimum Atlantic Loan amount of $2.0 million (Minimum Loan Amount), with 60 days notice, but not such that the payment would be required before February 1, 2003. Atlantic can demand payment of the Minimum Loan Amount with 90 days notice, but not such that payment would be required before August 1, 2003. Under the Atlantic Loan agreement, we can require Atlantic to loan us (1) up to $2.0 million to repay an amount due from CBTM to Unicorn, a related party to NaviSite and Atlantic; (2) $1.0 million for costs associated with our acquisition of Avasta; and (3) up to $500,000 for the post-acquisition working capital needs of Avasta. Atlantic, at its sole and absolute discretion, may advance other amounts to us such that the aggregate amount borrowed by NaviSite does not exceed the maximum loan amount, defined as the lesser of $10.0 million or 65% of our consolidated accounts receivables. At July 31, 2003, we had $3.0 million outstanding under the Atlantic Loan and had approximately $500,000 available to us. This amount is shown as Due to Affiliate on our Consolidated Balance Sheet. The Atlantic Loan is secured by all of our receivables. On May 30, 2003 we repaid $2.0 million of the approximate $3.0 million outstanding under the Atlantic Loan and on June 11, 2003, we borrowed $2.0 million under the Atlantic Loan.

 
(15) Selected Quarterly Financial Data (Unaudited)

      Financial information for interim periods was as follows:

                                 
Fiscal Year Ended July 31, 2003

Q1 Q2 Q3 Q4




(In thousands)
Revenue
  $ 15,871     $ 18,761     $ 19,620     $ 22,341  
Gross profit (deficit)
    (624 )     1,747       2,308       2,381  
Net loss
    (10,005 )     (20,231 )     (11,304 )     (32,085 )
Net loss per share(a)
  $ (1.60 )   $ (2.07 )   $ (0.88 )   $ (1.80 )

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NAVISITE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

                                 
Fiscal Year Ended July 31, 2002

Q1 Q2 Q3 Q4




(In thousands)
Revenue
  $ 19,279     $ 15,674     $ 14,717     $ 9,751  
Gross profit (deficit)
    (29,457 )     (11,859 )     4,552       (39,132 )
Net loss
    (44,340 )     (26,779 )     (2,044 )     (48,530 )
Net loss per share(a)
  $ (10.72 )   $ (4.70 )   $ (0.35 )   $ (7.97 )


 
(a) Net loss per common share is computed independently for each of the quarters based on the weighted average number of shares outstanding during the quarter. Therefore, the aggregate per share amount for the quarters may not equal the amount calculated for the full year.
 
(16) Subsequent Events

      On August 8, 2003, we completed the acquisition of certain assets and the assumption of certain liabilities of ClearBlue Technologies, Inc. pursuant to a Stock and Asset Acquisition Agreement (the “CBT Agreement”). Pursuant to the CBT Agreement, we acquired all outstanding shares of six (6) wholly-owned subsidiaries of ClearBlue Technologies, Inc. with data centers located in Chicago, Las Vegas, Los Angeles, Milwaukee, Oakbrook and Vienna.

      In addition, we exercised effective control over and assumed the revenue and expenses, as of the date of the CBT Agreement, of four (4) additional wholly-owned subsidiaries of ClearBlue Technologies, Inc. with data centers located in Dallas, New York, San Francisco and Santa Clara. Ownership of these subsidiaries will automatically be transferred, under certain conditions, to us for no additional consideration in February 2004.

      In exchange for these subsidiaries and certain assets and contracts relating to them, we: (i) issued 1.1 million shares of our common stock, to ClearBlue Technologies, Inc.; (ii) released ClearBlue Technologies, Inc. from certain inter-company advances in an amount up to $300,000; (iii) assumed all of ClearBlue Technologies, Inc.’s obligations under certain assets and contracts relating to the these subsidiaries; and (iv) released ClearBlue Technologies, Inc. from certain payment obligations owed to us pursuant to the Outsourcing Agreement in an amount not to exceed $263,000. The financial statement impacts have been reflected in these restated financial statements to account for this business combination of entities under common control in a manner similar to a pooling-of-interest.

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Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

ON FINANCIAL STATEMENT SCHEDULE

The Board of Directors and Stockholders

NaviSite, Inc. and Subsidiaries:

      Under date of October 21, 2003, we reported on the consolidated balance sheets of NaviSite, Inc. as of July 31, 2003 and 2002 and the related consolidated statements of operations, changes in stockholders’ equity (deficit), and cash flows for each of the fiscal years in the three-year period ended July 31, 2003, which are included in this Form S-2. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related consolidated financial statement schedule of Valuation and Qualifying Accounts in this Form S-2. This financial statement schedule is the responsibility of the Company’s management. Our responsibility is to express an opinion on this financial statement schedule based on our audits. In our opinion, such financial statement schedule when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

      The audit report on the consolidated financial statements of NaviSite, Inc. referred to above contains an explanatory paragraph that states that the Company’s recurring losses since inception and accumulated deficit, as well as other factors, raise substantial doubt about the entity’s ability to continue as a going concern. The financial statement schedule does not include any adjustments that might result from the outcome of this uncertainty.

/s/ KPMG LLP

Boston, Massachusetts

October 21, 2003

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Table of Contents

NAVISITE, INC. AND SUBSIDIARIES

VALUATION AND QUALIFYING ACCOUNTS

                                         
Years Ended July 31, 2003, 2002, and 2001

Balance at Additions Deductions Balance at
Beginning Charged to from End of
of Year Expense Other(1) Reserve Year





(In thousands)
Year ended July 31, 2001:
                                       
Allowance for doubtful accounts
  $ 1,219     $ 11,948     $     $ (6,308 )   $ 6,859  
Year ended July 31, 2002:
                                       
Allowance for doubtful accounts
  $ 6,859     $ 3,490     $     $ (9,732 )   $ 617  
Year ended July 31, 2003:
                                       
Allowance for doubtful accounts
  $ 617     $ 1,778     $ 3,119     $ (3,484 )   $ 2,030  


(1)  Represents allowance for doubtful accounts of CBTM (acquired in fiscal year 2003) and CBT (acquired in fiscal year 2004) which were accounted for in a manner similar to a pooling-of-interest due to common control ownership.

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Table of Contents

NAVISITE, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
                     
April 30, July 31,
2004 2003


(Unaudited)
(In thousands,
except par value)
ASSETS
Current assets:
               
 
Cash and cash equivalents
  $ 7,630     $ 3,862  
 
Accounts receivable, less allowance for doubtful accounts of $2,307 and $2,030 at April 30, 2004 and July 31, 2003, respectively
    13,583       14,741  
 
Due from related party
    12        
 
Prepaid expenses and other current assets
    4,224       4,011  
     
     
 
   
Total current assets
    25,449       22,614  
Property and equipment, net
    15,388       22,165  
Customer lists, less accumulated amortization of $6,696 and $3,724 at April 30, 2004 and July 31, 2003, respectively
    10,279       12,052  
Goodwill
    3,206       3,206  
Other assets
    5,913       6,280  
Restricted cash
    1,253       3,054  
     
     
 
   
Total assets
  $ 61,488     $ 69,371  
     
     
 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
               
 
Accounts receivable financing line, net
  $ 15,786     $ 6,358  
 
Notes payable, current portion
    1,048       1,211  
 
Capital lease obligations, current portion
    2,418       3,268  
 
Note payable to related party, current portion
    3,000       3,000  
 
Accounts payable
    3,856       4,371  
 
Accrued expenses
    13,628       17,580  
 
Deferred revenue
    2,196       2,993  
 
Customer deposits
    135       134  
     
     
 
   
Total current liabilities
    42,067       38,915  
Capital lease obligations, less current portion
    830       1,907  
Accrued lease abandonment, less current portion
    1,782       3,476  
Note to AppliedTheory Estate
    6,000       6,000  
Note payable
    1,352        
Other long-term liabilities
    737       2,194  
     
     
 
   
Total liabilities
    52,768       52,492  
     
     
 
Commitments and contingencies (Note 10) 
               
Stockholders’ equity:
               
 
Preferred stock, $0.01 par value; Authorized: 5,000 shares; Issued and outstanding: no shares at April 30, 2004 and July 31, 2003
           
 
Common stock, $0.01 par value; Authorized: 395,000 shares; Issued and outstanding: 24,829 and 23,412 at April 30, 2004 and July 31, 2003, respectively
    249       235  
 
Deferred compensation
    (1,699 )      
 
Accumulated other comprehensive income (loss)
    9       (16 )
 
Additional paid-in capital
    438,482       432,399  
 
Accumulated deficit
    (428,321 )     (415,739 )
     
     
 
   
Total stockholders’ equity
    8,720       16,879  
     
     
 
   
Total liabilities and stockholders’ equity
  $ 61,488     $ 69,371  
     
     
 

See accompanying notes to interim consolidated financial statements.

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Table of Contents

NAVISITE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

                                   
Three Months Ended Nine Months Ended
April 30, April 30,


2004 2003 2004 2003




(Unaudited) (Unaudited)
(In thousands, except per share data)
Revenue
  $ 20,173     $ 19,620     $ 65,975     $ 52,942  
Revenue, related parties
    12             12       1,310  
     
     
     
     
 
Total revenue
    20,185       19,620       65,987       54,252  
     
     
     
     
 
Cost of revenue
    14,217       17,312       48,899       50,821  
Impairment, restructuring and other
                633        
     
     
     
     
 
Total cost of revenue
    14,217       17,312       49,532       50,821  
     
     
     
     
 
Gross profit
    5,968       2,308       16,455       3,431  
     
     
     
     
 
Operating expenses:
                               
 
Product development
    230       121       890       624  
 
Selling and marketing
    1,848       1,429       5,724       3,759  
 
General and administrative
    6,097       5,023       16,342       13,718  
 
Impairment, restructuring and other
    206       3,819       1,608       6,274  
     
     
     
     
 
Total operating expenses
    8,381       10,392       24,564       24,375  
     
     
     
     
 
Loss from operations
    (2,413 )     (8,084 )     (8,109 )     (20,944 )
Other income (expense):
                               
 
Interest income
    18       169       115       685  
 
Interest expense
    (656 )     (2,470 )     (1,935 )     (20,170 )
 
Other income (expense), net
    25       (919 )     111       (1,111 )
     
     
     
     
 
Loss before income tax expense
    (3,026 )     (11,304 )     (9,818 )     (41,540 )
Income tax expense
                       
     
     
     
     
 
Net loss
  $ (3,026 )   $ (11,304 )   $ (9,818 )   $ (41,540 )
     
     
     
     
 
Basic and diluted net loss per common share
  $ (0.12 )   $ (0.88 )   $ (0.40 )   $ (4.33 )
     
     
     
     
 
Basic and diluted weighted average number of common shares outstanding
    24,809       12,845       24,685       9,587  
     
     
     
     
 

See accompanying notes to interim consolidated financial statements.

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NAVISITE, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

                     
Nine Months Ended
April 30,

2004 2003


(Unaudited)
(In thousands)
Cash flows from operating activities:
               
Net loss
  $ (9,818 )   $ (41,540 )
Adjustments to reconcile net loss to net cash used for operating activities:
               
 
Depreciation and amortization
    9,522       10,119  
 
Amortization of beneficial conversion feature to interest expense
          15,173  
 
Interest on debt paid in stock
          2,098  
 
Amortization of warrants
    304        
 
Non-cash stock compensation
    287        
 
Impairment of leased facilities
    1,941        
 
Impairment on long-lived assets
    300       (71 )
 
Impairment of assets held for sale
          1,042  
 
Impairment of goodwill and intangibles
          6,127  
 
Loss on disposal of assets
    26       250  
 
Provision for doubtful accounts
    1,902       753  
 
Changes in operating assets and liabilities, net of impact of acquisitions:
               
   
Accounts receivable
    (877 )     521  
   
Due from related parties
    (12 )     (3,533 )
   
Prepaid expenses and other current assets, net
    (220 )     808  
   
Other assets
    796       791  
   
Accounts payable
    (515 )     (1,211 )
   
Customer deposits
    1       (11 )
   
Accrued expenses and deferred revenue
    (4,920 )     (635 )
   
Other long-term liabilities
    (1,456 )     217  
     
     
 
Net cash used for operating activities
    (2,739 )     (9,102 )
     
     
 
Cash flows from investing activities:
               
 
Purchase of property and equipment
    (1,800 )     (579 )
 
Purchase of debt securities
          (1,963 )
 
Cash acquired, net of cash paid for businesses
          3,759  
 
Loans to related parties
          (1,396 )
 
Proceeds from the sale of equipment
    67       395  
     
     
 
Net cash (used for) provided by investing activities
    (1,733 )     216  
     
     
 
Cash flows from financing activities:
               
 
Decrease in restricted cash
    1,677       594  
 
Proceeds from exercise of stock options
    350        
 
Proceeds from sale-leaseback
    120        
 
Net proceeds from modified accounts receivable line
    16,000        
 
Proceeds from note payable
    450        
 
Repayment of note payable
    (1,581 )      
 
Borrowing under note to affiliate
          5,600  
 
Net repayment under former accounts receivable line
    (6,874 )      
 
Payments under note to affiliates
    (30 )     (2,600 )
 
Debt repayment to AppliedTheory Estate
          (6,100 )
 
Payment of capital lease obligations
    (1,872 )     (3,104 )
     
     
 
Net cash provided by (used for) financing activities
    8,240       (5,610 )
     
     
 
Net increase (decrease) in cash
    3,768       (14,496 )
Cash and cash equivalents, beginning of period
    3,862       21,842  
     
     
 
Cash and cash equivalents, end of period
  $ 7,630     $ 7,346  
     
     
 
Supplemental disclosure of cash flow information:
               
Cash paid during the period for:
               
 
Interest
  $ 1,044     $ 1,657  
 
Acquisitions of businesses:
               
   
Assets acquired
        $ 12,122  
   
Liabilities assumed
          (7,993 )
   
Common stock issued
          (370 )
     
     
 
   
Cash acquired, net of cash paid for businesses
        $ 3,759  
     
     
 

See accompanying notes to interim consolidated financial statements.

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NAVISITE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
1. Description of Business

      NaviSite, Inc. provides a broad range of outsourced hosting and managed application services for middle-market organizations, which include mid-sized companies, divisions of large multi-national companies and government agencies. Our service offerings allow our customers to outsource the hosting and management of their information technology infrastructure and applications, such as commerce systems, enterprise software applications and email. Substantially all of our revenue is generated from customers in the United States.

 
2. Significant Accounting Policies
 
     (a) Basis of Presentation

      The accompanying interim consolidated financial statements have been prepared by NaviSite, Inc. (NaviSite, we, us or our) in accordance with accounting principles generally accepted in the United States of America and pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. It is suggested that the interim consolidated financial statements be read in conjunction with the audited consolidated financial statements and the accompanying notes included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on October 22, 2003 and elsewhere in this Information Statement.

      The information furnished reflects all adjustments, which, in the opinion of management, are of a normal recurring nature and are considered necessary for a fair presentation of results for the interim periods. Such adjustments consist only of normal recurring items. It should be noted that results for interim periods are not necessarily indicative of the results expected for the full year or any future period.

      The preparation of these interim consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities on the date of the financial statements and the reported amounts of revenue and expenses during the reporting period.

One-for-fifteen Reverse Stock Split

      On December 12, 2002, our board of directors, pursuant to authority previously granted by our stockholders at the annual meeting on December 19, 2001, approved a reverse stock split of our common stock at a ratio of one-for-fifteen (1:15) effective January 7, 2003. All per share amounts and number of shares outstanding have been restated to give effect to the reverse stock split.

Impact of Acquisitions

      On August 8, 2003, we completed the acquisition of certain assets and the assumption of certain liabilities of ClearBlue Technologies, Inc. (CBT) pursuant to a Stock and Asset Acquisition Agreement (the CBT Agreement). We acquired all outstanding shares of six (6) wholly owned subsidiaries of CBT with data centers located in Chicago, Las Vegas, Los Angeles, Milwaukee, Oakbrook and Vienna. In addition, we assumed the revenue and expense, as of the date of acquisition, of four (4) additional wholly owned subsidiaries of CBT with data centers located in Dallas, New York, San Francisco and Santa Clara (collectively the “Four Subsidiaries” or the “Deferred Entities”). Ownership of these subsidiaries was to be automatically transferred, under certain conditions, to NaviSite for no additional consideration in February 2004 (the CBT Agreement was amended in February 2004, as described below). The operational

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NAVISITE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

results of the Four Subsidiaries have been included herein since NaviSite exercised effective control over these subsidiaries as of August 8, 2003.

      As Atlantic Investors, LLC had a controlling interest in both NaviSite and CBT at the time of the combination, the transaction was accounted for as a combination of entities under common control (i.e., “as if pooling”) whereby the assets and liabilities of CBT and NaviSite were combined at their historical amounts. Accordingly, our consolidated financial statements have been restated for all periods prior to the business combination to include CBT’s financial results beginning on September 11, 2002, the date on which CBT acquired the controlling interest in NaviSite, after the elimination of intercompany balances. See Note 6 for further discussion of our fiscal year 2003 and 2004 acquisitions.

      On February 6, 2004, we entered into an amendment to the CBT Agreement (the “Amendment”) by and among NaviSite, CBT and certain of CBT’s wholly owned subsidiaries. The Amendment amended the CBT Agreement dated August 8, 2003 to extend the date by which we are able to cause the transfer to us of the Deferred Entities, from February 8, 2004 to anytime on or prior to August 8, 2005 (the “Transfer Date”), under certain conditions and for no additional consideration. In consideration for such Amendment, we agreed to operate and manage the Deferred Entities in a manner consistent with the CBT Agreement.

      On March 12, 2004, we had initially rejected the Santa Clara data center subsidiary, pursuant to our right under the acquisition agreement; however, on April 12, 2004, prior to the expiration of the thirty-day notification period, we revoked this rejection. On April 14, 2004, pursuant to the Amendment, NaviSite exercised its right to acquire from CBT all of the outstanding shares of the Deferred Entities, for no additional consideration. We will continue to consolidate, as part of our consolidated financial statements, the results of each of these four subsidiaries.

 
     (b) Principles of Consolidation

      The accompanying consolidated financial statements include the accounts of NaviSite, Inc. and our wholly owned subsidiaries, ClickHear, Inc., NaviSite Acquisition Corp., ClearBlue Technologies Management, Inc., Avasta, Inc., Conxion Corporation, Intrepid Acquisition Corp., ClearBlue Technologies/Chicago-Wells, Inc., ClearBlue Technologies/Las Vegas, Inc., ClearBlue Technologies/Los Angeles, Inc., ClearBlue Technologies/Milwaukee, Inc., ClearBlue Technologies/Oakbrook, Inc., and ClearBlue Technologies/Vienna, Inc., ClearBlue Technologies/New York, Inc., ClearBlue Technologies/ Dallas, Inc., ClearBlue Technologies/ Santa Clara, Inc. and ClearBlue Technologies/San Francisco, Inc. after elimination of all significant intercompany balances and transactions.

 
     (c) Use of Estimates

      The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect certain reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. Actual results could differ from those estimates. Significant estimates made by management include the useful lives of fixed assets and intangible assets, recoverability of long-lived assets and the collectability of receivables.

 
     (d) Cash and Cash Equivalents and Restricted Cash

      Cash equivalents consist of a money market fund, which invests in high quality short-term debt obligations, including commercial paper, asset-backed commercial paper, corporate bonds, U.S. government agency obligations, taxable municipal securities, and repurchase agreements. The

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NAVISITE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Company had restricted cash of $1.3 million and $3.1 million at April 30, 2004 and July 31, 2003, respectively, which represents a cash collateral requirement for standby letters of credit associated with several of the Company’s facility and equipment leases. Restricted cash declined by $1.8 million during the nine months ended April 30, 2004, as the result of letters of credit that have expired, been drawn down or canceled due to lease modifications.

 
     (e) Revenue Recognition

      Revenue consists of monthly fees for Web site and Internet application management, application rentals, hosting, co-location, and professional services. Revenue (other than installation fees) is billed and recognized over the term of the contract, generally one to three years, based on actual usage. Payments received in advance of providing services are deferred until the period such services are provided. Revenue from professional services is recognized on a time-and-material basis as the services are performed or under the percentage of completion method for revenue relating to fixed-price contracts. We generally sell our professional services under contracts with terms ranging from one to five years. Revenue and profits on long-term Internet solutions contracts, which represent approximately 2% of total revenue for the three and nine-month periods ended April 30, 2004, performed over extended periods are recognized under the percentage-of-completion method of accounting, with adjustments recorded in the period in which the revisions are made. Any anticipated losses on contracts are charged to operations as soon as they are determinable.

 
     (f) Concentrations of Credit Risk

      Our financial instruments include cash, accounts receivable, obligations under capital leases, software agreements, accounts payable, and accrued expenses. As of April 30, 2004, the carrying cost of these instruments approximated their fair value. Financial instruments that potentially subject us to concentration of credit risk consist primarily of accounts receivable. Concentrations of credit risk with respect to trade receivables are limited due to the large number of customers across many industries that comprise our customer base. One third-party customer accounted for 13% and 24% of our total revenue for the nine months ended April 30, 2004 and 2003, respectively. Accounts receivable at April 30, 2004 include approximately $1.7 million due from this third-party customer.

 
     (g) Comprehensive Income (Loss)

      Comprehensive income (loss) is defined as the change in equity from foreign currency translation adjustments.

 
     (h) Goodwill and Intangible Assets

      At April 30, 2004 and July 31, 2003, our intangible assets consisted of customer lists resulting from our acquisitions of Avasta, Inc. and certain assets and liabilities of Interliant and the “as if poolings” of CBTM and CBT. Our intangible assets were recorded at a gross carrying value of $17.0 million and $15.8 million, less accumulated amortization of $6.7 million and $3.7 million at April 30, 2004 and July 31, 2003, respectively. Amortization expense related to our intangible assets of $2.6 million and $1.8 million for the nine months ended April 30, 2004 and 2003, respectively, was recorded as a component of our cost of revenue. Goodwill, resulting from our acquisition of CBTM, is recorded at its gross carrying value of $3.2 million. We perform our annual impairment analysis in our fiscal fourth quarter.

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NAVISITE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 
     (i) Accounting for Impairment of Long-Lived Assets

      We assess the need to record impairment losses on long-lived assets used in operations when indicators of impairment are present. On an ongoing basis, management reviews the value and period of amortization or depreciation of long-lived assets. During this review, the significant assumptions used in determining the original cost of long-lived assets are reevaluated. Although the assumptions may vary from transaction to transaction, they generally include revenue growth, operating results, cash flows, and other indicators of value. Management then determines whether there has been a permanent impairment of the value of long-lived assets by comparing future undiscounted cash flows to the asset’s carrying value. If the estimated future undiscounted cash flows are less than the carrying value of the asset, a loss is recorded based on the excess of the asset’s carrying value over fair value.

 
     (j) Income Taxes

      We account for income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

 
     (k) Net Loss Per Share

      Basic net loss per share is computed using the weighted average number of common shares outstanding during the period. Diluted net loss per share is computed using the weighted average number of common and dilutive common equivalent shares outstanding during the period using the treasury stock method for warrants and options, unless such amounts are anti-dilutive.

      For the three and nine months ended April 30, 2004 and 2003, net loss per basic and diluted share is based on weighted average common shares and excludes any common stock equivalents, as they would be anti-dilutive due to the reported net loss. For the three and nine months ended April 30, 2004, 1,228,532 and 1,190,034, respectively, of dilutive shares related to warrants and employee stock options were excluded as they had an anti-dilutive effect due to the net loss. For the three and nine months ended April 30, 2003, 3,041 and 3,987, respectively, of dilutive shares related to employee stock options were excluded as they had an anti-dilutive effect due to the net loss. (See Note 11)

 
     (l) Stock-Based Compensation

      We account for our stock option plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees, and Related Interpretations.” We recorded stock compensation expense of approximately $69,000 and $287,000 during the three and nine months ended April 30, 2004, respectively (see Note 11). The following table illustrates the effect on net loss and net loss per common share if we had applied the fair value recognition provisions of Financial Accounting Standards Board (“FASB”) Statement No. 123,

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NAVISITE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

“Accounting for Stock-Based Compensation”, to stock-based compensation (in thousands, except per share data):

                                 
Three Months Ended Nine Months Ended
April 30, April 30,


2004 2003 2004 2003




Net loss, as reported
  $ (3,026 )   $ (11,304 )   $ (9,818 )   $ (41,540 )
Add: Stock-based employee compensation expense from the Amended and Restated 2003 Stock Incentive Plan included in reported net loss, net of related tax effects
    69             287        
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects
    (1,437 )     (1,541 )     (4,240 )     (7,033 )
     
     
     
     
 
Net loss, as adjusted
  $ (4,394 )   $ (12,845 )   $ (13,771 )   $ (48,573 )
     
     
     
     
 
Net loss per common share:
                               
Basic and diluted, as reported
  $ (0.12 )   $ (0.88 )   $ (0.40 )   $ (4.33 )
     
     
     
     
 
Basic and diluted, as adjusted
  $ (0.18 )   $ (1.00 )   $ (0.56 )   $ (5.07 )
     
     
     
     
 

      The fair value of each stock option is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions:

                                 
Three Months Ended Nine Months Ended
April 30, April 30,


2004 2003 2004 2003




Risk-free interest rate
    2.86 %     2.06 %     2.15 %     2.06 %
Expected dividend yield
    0.00 %     0.00 %     0.00 %     0.00 %
Expected volatility
    135.71 %     140.69 %     160.68 %     161.24 %
Expected life (years)
    2.48       3.06       2.75       3.06  
Weighted average fair value of options granted during the period
  $ 5.13       N/A     $ 5.89     $ 2.88  
 
     (m) Segment Reporting

      We currently operate in one segment, outsourced hosting and application management services. The Company’s chief operating decision maker reviews financial information at a consolidated level. The Company has determined that reporting revenue at a service offering level is impracticable.

 
     (n) New Accounting Pronouncements

      In January 2003, FASB Interpretation No. (“FIN”) 46, “Consolidation of Variable Interest Entities,” was issued. FIN 46 requires certain variable interest entities (“VIE”) to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective for all new VIEs created or acquired after January 31, 2003. During December 2003, the FASB issued a new revision to FIN 46 (“FIN 46R”). Under the revised provisions, public entities are required to apply the guidance if the entity has interests in VIEs commonly referred to as special-purpose entities for the periods ending after December 15, 2003. The adoption of FIN 46 and 46R did not have a material effect on our consolidated financial statements.

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NAVISITE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      In May 2003, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 150, “Accounting For Certain Financial Instruments with Characteristics of Both Liabilities and Equity”, which establishes standards for how an issuer of financial instruments classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) if, at inception, the monetary value of the obligation is based solely or predominantly on a fixed monetary amount known at inception, variations in something other than the fair value of the issuer’s equity shares or variations inversely related to changes in the fair value of the issuer’s equity shares. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. On November 7, 2003 the FASB deferred the classification and measurement provisions of SFAS No. 150 as they apply to certain mandatory redeemable non-controlling interests. This deferral is expected to remain in effect while these provisions are further evaluated by the FASB. We have not entered into or modified any financial instruments covered by this statement after May 31, 2003 and the application of this standard is not expected to have a material impact on our financial position or results of operations.

      In December 2003, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition,” which supersedes SAB 101, “Revenue Recognition in Financial Statements.” SAB 104’s primary purpose is to rescind accounting guidance contained in SAB 101 related to multiple element revenue arrangements, superseded as a result of the issuance of Emerging Issues Task Force (“EITF”) 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables.” The issuance of SAB 104 reflects the concepts contained in EITF 00-21; the other revenue recognition concepts contained in SAB 101 remain largely unchanged. The application of SAB 104 did not have a material impact on the Company’s financial position or results of operations.

 
     (o) Reclassifications

      Certain fiscal year 2003 balances have been reclassified to conform to the fiscal year 2004 financial statement presentation.

 
     (p) Foreign Currency

      The functional currencies of our foreign wholly owned subsidiaries are the local currencies. The financial statements of the subsidiaries are translated into U.S. dollars using period end exchange rates for assets and liabilities and average exchange rates during corresponding periods for revenue, cost of revenue and expenses. Translation gains and losses are deferred and accumulated as a separate component of stockholders’ equity (accumulated other comprehensive income (loss)).

 
3. Liquidity

      As of April 30, 2004, our principal sources of liquidity include cash and cash equivalents and our financing agreement with Silicon Valley Bank. We had a working capital deficit of $16.6 million, including cash and cash equivalents of $7.6 million at April 30, 2004, as compared to a working capital deficit of $16.3 million, including cash and cash equivalents of $3.9 million at July 31, 2003.

      The total net change in cash and cash equivalents for the nine months ended April 30, 2004 was an increase of $3.8 million. The primary uses of cash during this nine-month period included $2.7 million of cash used for operating activities, $1.8 million for purchases of property and equipment and $10.4 million in repayments on notes payable, capital lease obligations and borrowings under our former accounts receivable financing line. Our primary sources of cash during this nine-month period were a $1.7 million decrease in restricted cash, $0.4 million in proceeds associated with the exercise of stock options under the employee stock option plans, $16.0 million in net proceeds from our modified financing agreement and

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NAVISITE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

$0.6 million in proceeds from sale-leaseback and note payable transactions. Net cash used for operating activities of $2.7 million for the nine months ended April 30, 2004, resulted primarily from our $9.8 million net loss, partially offset by $14.3 million in non-cash charges, and $7.2 million used by net changes in operating assets and liabilities. At April 30, 2004, we had an accumulated deficit of $428.3 million, and have reported losses from operations since incorporation. At July 31, 2003, we had an accumulated deficit of $415.7 million.

      Prior to May 2003, our primary sources of cash to fund our operations were sales of equity and convertible debt securities. Since May 2003, our primary source of cash to fund our operations and meet our contacted obligations and commitments has been our accounts receivable financing agreement with Silicon Valley Bank. On January 30, 2004, we amended this agreement to, among other things, allow for future borrowing to be based on monthly recurring revenue, increase the maximum borrowings level from $10.0 million to $12.8 million, and extend the term until January 29, 2006. On April 29, 2004, we amended this agreement, among other things, to increase the maximum borrowing level from $12.8 million to $20.4 million, and extend the term until April 29, 2006. Under the amended agreement, borrowings are based on monthly recurring revenue. We are required to prepare and deliver a written request for an advance of up to three times the value of total monthly recurring revenue, calculated to be monthly revenue (including revenue from New York State Department of Labor) less professional services revenue. The bank may then provide an advance of 85% of such value (or such other percentage as the bank may determine). The interest rate under the amended agreement is variable and is currently calculated at the bank’s published “prime rate” plus four percent. Following the completion of certain equity and debt financings, and provided we continue to meet certain ratios under the amended agreement, the interest rate shall be reduced to the bank’s prime rate plus one percent. In no event, however, will the bank’s prime rate be less than 4.25%. On April 30, 2004, we had an outstanding balance under the amended agreement of $16.0 million. On June 11, 2004, we borrowed approximately $3.9 million under the Silicon Valley Bank amended agreement to repay a Surebridge loan with Silicon Valley Bank that we assumed as part of the Surebridge acquisition (see Note 13). Our outstanding balance under this amended agreement as of June 11, 2004, was $15.2 million.

      We anticipate incurring additional losses throughout our current fiscal year. We have taken several actions we believe will allow us to continue as a going concern through July 31, 2004, including the closing and integration of strategic acquisitions, the changes to our senior management and bringing costs more in line with projected revenue. On January 22, 2004, we filed with the Securities and Exchange Commission a registration statement on Form S-2 (amended Form S-2/A filed on June 29, 2004) to register shares of our common stock to issue and sell in a public offering to raise additional funds. We believe that this proposed offering will allow us to raise the necessary funds to meet our anticipated needs for working capital and capital equipment for at least 12 months following the proposed offering. However, there can be no assurance that we will complete the proposed offering. In the event we are unable to complete the proposed offering, we will need to find alternative sources of financing, in order to remain a going concern. Potential sources include our financing agreement with Silicon Valley Bank and public or private sales of equity or debt securities. We may also consider sales of assets to raise additional cash. If we use a significant portion of the net proceeds from an offering to acquire a company, technology or product, we will need to raise additional debt or equity capital.

      During fiscal 2003, we acquired four companies, downsized our workforce and restructured our business and balance sheet to improve operating cash flow. Our operating forecast incorporates material trends, such as our acquisitions, reductions in workforce, loss of related party revenue and closings of facilities. Our forecast also incorporates the future cash flow benefits expected from our continued efforts to increase efficiencies and reduce redundancies. Nonetheless, our forecast includes the need to raise additional funds through the proposed offering or alternate sources of financing. Our cash flow estimates are based upon attaining certain levels of sales, maintaining budgeted levels of operating expenses,

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Table of Contents

NAVISITE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

collections of accounts receivable and maintaining our current borrowing line with Silicon Valley Bank among other assumptions, including the improvement in the overall macroeconomic environment. However there can be no assurance that we will be able to meet such assumptions. Our sales estimate includes revenue from new and existing customers which may not be realized and we may be required to further reduce expenses if budgeted sales are not attained. We may be unsuccessful in reducing expenses in proportion to any shortfall in projected sales and our estimate of collections of accounts receivable may be hindered by our customers’ ability to pay. In addition, we are currently involved in various pending and potential legal proceedings. While we believe that the allegations against us in each of these matters are without merit, and that we have meritorious defense in each, we are not able to predict the final outcomes of any of these matters and the effect, if any, on our financial condition. If we are ultimately unsuccessful in any of these matters, we could be required to pay substantial amounts of cash and/or shares of our common stock to the other parties. The amount and timing of any such payments could adversely affect our financial condition.

 
4. Intangible Assets

      Intangible assets as of April 30, 2004 are as follows (in thousands):

                 
Gross Carrying Accumulated
Amount Amortization


Customer Lists
  $ 16,975     $ 6,696  
     
     
 

      During the three months ended April 30, 2004, we finalized our purchase accounting for the valuation of identifiable intangible assets of Avasta, Inc., which resulted in a reclassification from leasehold improvements to an intangible asset allocated to customer list in the amount of approximately $1.5 million. In addition, we reduced intangible assets during the third quarter of 2004 by $325,000, as the result of the Interliant net worth adjustment, which was resolved during the quarter (see Note 9(d)). Intangible asset amortization expense for the three-month period ended April 30, 2004 and 2003 aggregated $920,000 and $677,000, respectively, and for the nine-month period ended April 30, 2004 and 2003 was $2.6 million and $1.8 million, respectively. The amount reflected in the table below for fiscal year 2004 includes year-to-date amortization. Amortization expense related to intangible assets for the next five years is as follows (in thousands):

         
Year Ending July 31,

2004
  $ 3,466  
2005
  $ 3,276  
2006
  $ 2,953  
2007
  $ 2,003  
2008
  $ 1,115  
 
5. Property and Equipment

      Property and equipment are stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets. Leasehold improvements and assets acquired under capital leases are amortized using the straight-line method over the shorter of the lease term or estimated useful life of the asset. Assets acquired under capital leases in which title transfers to us at the end of the agreement are amortized over the useful life of the asset. Expenditures for maintenance and repairs are

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NAVISITE, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

charged to expense as incurred. Property and equipment, net at April 30, 2004 and July 31, 2003 are summarized as follows (in thousands):

                 
April 30, July 31,
2004 2003


Office furniture and equipment
  $ 2,367     $ 2,613  
Computer equipment
    29,876       28,368  
Software licenses
    9,553       9,308  
Leasehold improvements
    10,820       12,549  
     
     
 
      52,616       52,838  
Less: Accumulated depreciation and amortization
    (37,228 )     (30,673 )
     
     
 
Property and equipment, net
  $ 15,388     $ 22,165  
     
     
 
 
6. Acquisitions

      CBTM. We acquired ClearBlue Technologies Management, Inc. (CBTM) in December 2002 in a transaction accounted for as a combination of entities under common control (i.e., “as if pooling”). In June 2002, prior to our acquisition of CBTM, CBTM acquired substantially all of the assets used or useful in the Web hosting and Internet solutions business and assumed certain associated liabilities from the bankruptcy estate of AppliedTheory Corporation (AppliedTheory), which had filed for bankruptcy on April 17, 2002. On June 13, 2002, the acquisition of AppliedTheory by CBTM was consummated, effective June 6, 2002. The results of operations of AppliedTheory have been included in the financial statements of CBTM since June 6, 2002.

      The aggregate purchase price paid by CBTM for the AppliedTheory assets, excluding assumed liabilities, was $16.0 million of which $3.9 million was paid in cash and $12.1 million was satisfied through the issuance of four notes payable to the AppliedTheory Estate: two unsecured promissory notes totaling $6.0 million, bearing interest at 8% per annum and due June 10, 2006, a secured promissory note totaling $700,000, bearing interest at 8% per annum and due December 10, 2002 and a $5.4 million secured promissory note, non-interest bearing, due December 10, 2002. The two notes, due December 10, 2002, were paid in December 2002.

      Of the $6.2 million in identifiable intangible assets, $5.8 million was assigned to customer lists, which are being amortized over eight years, except for the New York State Department of Labor customer contract, which is being amortized over five years, and represented the remaining life on the contract. The remaining $440,000 of acquired intangible assets was allocated to proprietary software, which is being amortized over five years.

      Avasta, Inc. On February 5, 2003, we acquired Avasta, a provider of remote hosting and managed service operations, in an all-stock transaction valued at approximately $370,000. The acquisition was made to enhance our ability to be a full service provider of applications management services and technology to our customers. The purchase price consisted of 231,039 shares of common stock at a per share value of $1.60 (representing a five-day average of the market value of our common stock at the time of the acquisition). The purchase price of $442,000 consists of the issuance of common stock for approximately $370,000 and approximately $72,000 in acquisition costs. This acquisition was accounted for using the purchase method of accounting. The Agreement and Plan of Merger provided that up to an additional 1,004,518 shares of common stock could be issued in the event certain revenue targets were achieved through June 2003. As a result of the earnout calculation in September 2003, we adjusted our purchase accounting to reflect the issuance of 179,353 shares of our common stock at a per share value of $4.14 (representing the market value of our common stock the day preceding the issuance of the additional

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shares for the attainment of certain revenue targets). During the third quarter of 2004, we finalized our purchase accounting for this acquisition, which resulted in the reclassification from leasehold improvements to an intangible asset allocated to customer lists in the amount of approximately $1.5 million, which is being amortized over the remaining four years.

      Conxion Corporation. On April 2, 2003, we completed the acquisition of Conxion, a provider of software distribution services and network/server security expertise for its customers, pursuant to an Agreement and Plan of Merger, dated as of March 26, 2003 (Conxion Agreement), by and between us, Union Acquisition Corp., a Delaware corporation and our wholly owned subsidiary, and Conxion. Pursuant to the Conxion Agreement, the shareholders of Conxion received an aggregate of $1,925,000 in cash. The acquisition was made to enhance our ability to be a full service provider of applications management services and technology to our customers. The source of funds used for the acquisition of Conxion was our cash on hand. The acquisition price was based on the parties’ determination of the fair value of Conxion and the terms of the Conxion Agreement were derived from arms-length negotiation among the parties. The purchase price of $2,031,000 consisted of the $1,925,000 paid to the Conxion shareholders and approximately $106,000 in acquisition costs. The negative goodwill of approximately $2.2 million reduced the recorded basis of property and equipment. This acquisition was accounted for using the purchase method of accounting.

      Interliant. On May 16, 2003, we completed the acquisition of substantially all of the assets relating to the managed infrastructure solutions business, encompassing messaging and collaboration, managed hosting, bundled-in managed security, and integrated and related professional services in the United States and in Europe of Interliant, Inc., a Delaware corporation, and several of its subsidiaries (Debtors) in the bankruptcy proceedings of the Debtors under Chapter 11 of Title 11 of the United States Bankruptcy Code pending in the Southern District of New York (White Plains), pursuant to an Asset Purchase Agreement, dated as of May 15, 2003 (the Agreement), by and between our subsidiary, Intrepid Acquisition Corp. and the Debtors, approved by order of the Bankruptcy Court on May 15, 2003. Pursuant to the Agreement, the aggregate purchase price for the Interliant assets, excluding certain assumed liabilities, was approximately $7,204,000 after adjustments, based upon the Debtors’ adjusted net worth, comprised of approximately $5,830,000 in cash, $624,000 in the form of a credit of future distributions to be paid on the Interliant Notes, $550,000 in principal amount of a non-interest bearing, 180-day promissory note, secured by the Interliant Notes and the accounts receivable acquired as part of the Interliant Assets and approximately $200,000 in acquisition-related costs. On May 16, 2003, our subsidiary closed on the purchase of all of the Interliant Assets, other than the Debtors’ accounts receivable. On June 6, 2003, our subsidiary closed on the purchase of the accounts receivable. The source of funds used for the initial closing was our cash on hand combined with the funds provided from and through financing of our accounts receivable with Silicon Valley Bank (SVB), as discussed below, cash acquired with the Interliant assets, and cash receipts from the purchased accounts receivable. The acquisition price was determined through arms-length negotiations and competitive bidding for the Interliant Assets at an auction conducted under the auspices of the Bankruptcy Court. On March 8, 2004, the court approved the $325,000 net worth adjustment in favor of Intrepid and we adjusted our purchase accounting to reflect this resolution. In conjunction with this resolution, Intrepid’s $550,000 promissory note in favor of Interliant was satisfied out of the net worth adjustment and the remaining balance of $225,000 was paid from funds Intrepid had placed in escrow (see Note 9).

      ClearBlue Technologies. On August 8, 2003, we completed the acquisition of certain assets and the assumption of certain liabilities of CBT pursuant to a Stock and Asset Acquisition Agreement (the “CBT Agreement”). Pursuant to the CBT Agreement, we acquired all outstanding shares of six (6) wholly owned subsidiaries of CBT with data centers located in Chicago, Las Vegas, Los Angeles, Milwaukee, Oakbrook and Vienna.

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      In addition, we assumed the revenue and expense, as of the date of the CBT Agreement, of four (4) additional wholly owned subsidiaries of CBT with data centers located in Dallas, New York, San Francisco and Santa Clara. Ownership of these subsidiaries was to be automatically transferred, under certain conditions, to us for no additional consideration in February 2004. On February 6, 2004, we entered into an amendment (as discussed in Note 2) to extend the date by which we are able to cause the transfer of these CBT wholly owned subsidiaries to us from February 8, 2004 to on or prior to August 8, 2005, under certain conditions and for no additional consideration. In consideration for such amendment, we agreed to operate and manage these entities in a manner consistent with the CBT Agreement.

      In exchange for these subsidiaries and certain assets and contracts relating to them, we: (i) issued 1.1 million shares of our common stock, to CBT; (ii) released CBT from certain inter-company advances in an amount up to $300,000; (iii) assumed all of CBT’s obligations under certain assets and contracts relating to these subsidiaries; and (iv) released CBT from certain payment obligations owed to us pursuant to the Outsourcing Agreement in an amount not to exceed $263,000.

      As Atlantic Investors, LLC had a controlling interest in both NaviSite and CBT at the time of the CBT Agreement, the transaction was accounted for as a combination of entities under common control (i.e., “as if pooling”) whereby the assets and liabilities of CBT and NaviSite were combined at their historical amounts. Accordingly, the Company’s consolidated financial statements have been restated for all periods prior to the business combination to include CBT’s financial results beginning on September 11, 2002, the date on which CBT acquired the controlling interest in the Company. CBT’s balance sheet has been included in the Consolidated Balance Sheets of NaviSite at April 30, 2004 and July 31, 2003, and CBT’s results of operations and cash flows for the nine months ended April 30, 2004 have been included in the Consolidated Statement of Operations and Consolidated Statement of Cash Flows of NaviSite for the nine-month period ended April 30, 2004, and CBT’s results of operations and cash flows for the eight-month period ended April 30, 2003 have been included in our Consolidated Statement of Operations and Consolidated Statement of Cash Flows for the nine-month period ended April 30, 2003.

      On March 12, 2004, we had initially rejected the Santa Clara data center subsidiary, pursuant to our right under the acquisition agreement; however, on April 12, 2004, prior to the expiration of the thirty-day notification period, we revoked this rejection. On April 14, 2004, pursuant to the Amendment, NaviSite exercised its right to acquire from CBT all of the outstanding shares of the Deferred Entities, for no additional consideration. We will continue to consolidate, as part of our consolidated financial statements, the results of each of these four subsidiaries.

      The following unaudited pro forma results for the nine-month period ended April 30, 2003 give effect to our acquisitions of CBTM, Avasta, Conxion and the assets of Interliant and CBT as if they had taken place at the beginning of fiscal year 2003. The pro forma information does not necessarily reflect the results of operations that would have occurred had the acquisitions taken place at the beginning of the fiscal 2003 period and is not necessarily indicative of results that may be obtained in the future (in thousands, except per share data):

         
For the Nine Months
Ended April 30, 2003

Pro Forma

Revenue
  $ 91,120  
Net loss
  $ (57,485 )
Net loss per common share
  $ (6.00 )

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7. Investment in Debt Securities

      In a privately negotiated transaction with Fir Tree Recovery Master Fund, LP and Fir Tree Value Partners, LDC pursuant to an Assignment Agreement dated October 11, 2002 and in a series of open market transactions from certain other third-party holders, we acquired an aggregate principal amount of approximately $36.3 million face value, 10% convertible senior notes (Interliant Notes) due in 2006 of Interliant, Inc. (Interliant) for a total consideration of approximately $2 million. Interliant is a provider of managed services, which filed a petition under Chapter 11 of the United States Bankruptcy Code in the Southern District of New York on August 5, 2002, and we made this investment with the intention of participating in the reorganization/sale of Interliant.

      On May 16, 2003, the Southern District of New York (White Plains) confirmed us as the successful bidder for the purchase of the Interliant assets. The final value we will receive for the Interliant Notes has not been determined, however, we estimate the value to approximate the $1.4 million carrying value, included in other assets on our Consolidated Balance Sheet. The Interliant Estate filed a plan of liquidation with the bankruptcy court, which has been approved by the creditors.

 
8. Accrued Expenses

      Accrued expenses consist of the following at April 30, 2004 and July 31, 2003, respectively (in thousands):

                 
April 30, July 31,
2004 2003


Accrued payroll, benefits and commissions
  $ 2,528     $ 3,088  
Accrued accounts payable
    2,102       3,694  
Accrued interest
    899       351  
Due to AppliedTheory Estate
    1,464       1,461  
Accrued contract termination fees
    524       2,096  
Accrued lease abandonment costs
    2,285       2,536  
Accrued taxes
    782       708  
Accrued other
    3,044       3,646  
     
     
 
    $ 13,628     $ 17,580  
     
     
 
 
9. Debt
 
     (a) Silicon Valley Bank Financing Arrangements

      On May 27, 2003, we entered into an Accounts Receivable Financing Agreement (Financing Agreement), by and among Silicon Valley Bank (SVB), us and our wholly owned subsidiaries, ClearBlue Technologies Management, Inc., Avasta, Inc., Conxion Corporation and Intrepid Acquisition Corp., whereby we can finance up to a maximum of $12.5 million of our eligible accounts receivables with an 80% advance rate. Under the Financing Agreement, we are required to repay advances upon the earlier of our receipt of payment on the financed accounts receivables from our customers, or the financed accounts receivable being aged greater than ninety days from date of service. The Financing Agreement has a one-year term and bears an annual interest rate of prime rate plus 4.0%, with a minimum $10,000 monthly finance charge. The Financing Agreement also contains certain affirmative and negative covenants and is secured by substantially all of our assets, tangible and intangible. As part of the Financing Agreement, on May 27, 2003 we issued to SVB a warrant to purchase up to 165,000 shares of NaviSite common stock with an exercise price of $2.50 per share, the closing price of our stock on the last business day before the

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issuance of the warrant. We fair valued the warrants at $370,000 using the Black-Scholes option-pricing model. The value of the warrants is being amortized into interest expense over the term of the Financing Agreement. Pursuant to the terms of the warrant, on May 19, 2004, SVB fully exercised its warrant, which resulted in a net issuance of 73,738 shares.

      On January 30, 2004, we entered into a Loan Modification Agreement with SVB. The agreement amended our accounts receivable financing agreement with SVB, among other things, to: (i) base future borrowings on monthly recurring revenue; (ii) increase the maximum borrowing level from $10.0 million to $12.8 million; and (iii) extend the term until January 29, 2006. In connection with this amended agreement, on January 30, 2004, we issued a warrant to SVB for the purchase of 50,000 shares of common stock at an exercise price of $5.75 per share. We fair valued the warrant at $213,426 using the Black-Scholes option-pricing model. The value of the warrant is being amortized into interest expense over the term of the modified Financing Agreement. The warrant is exercisable at any time on or after September 1, 2004. Pursuant to the terms of a Registration Rights Agreement, dated as of January 30, 2004, we also granted certain registration rights to SVB with respect to the shares of common stock issuable upon exercise of the warrant.

      On April 29, 2004, we entered into a Second Loan Modification Agreement with SVB. The agreement amended our account receivable financing agreement, with SVB to, among other things: (i) increase our maximum borrowing level from $12.8 million to $20.4 million; and (ii) extend the term until April 29, 2006. On April 30, 2004, we had an outstanding balance under the amended agreement of $16.0 million and repaid $7.0 million on May 3, 2004.

      Under the amended agreement, borrowings are based on monthly recurring revenue. We are required to prepare and deliver a written request for an advance of up to three times the value of total recurring monthly revenue, calculated to be monthly revenue (including revenue from The New York State Department of Labor) less professional services revenue. SVB may then provide an advance of 85% of such value (or such other percentage as the bank may determine). The interest rate under the amended agreement is variable and is currently calculated at the bank’s published “prime rate” plus 4.0%. Following the completion of certain equity or debt financings, and provided we continue to meet certain ratios under the amended agreement, the interest rate shall be reduced to the bank’s prime rate plus 1.0%. In no event, however, will the bank’s prime rate be less than 4.25%.

 
     (b) Note Payable to Atlantic Investors, LLC (Atlantic)

      On January 29, 2003, we entered into a $10 million Loan and Security Agreement (Atlantic Loan) with Atlantic, a related party. The Atlantic Loan bears an interest rate of 8% per annum. Interest is payable upon demand or, at Atlantic’s option, interest may be added to the outstanding balance due to Atlantic by NaviSite. Atlantic may make demand for payment of amounts in excess of the minimum Atlantic Loan amount of $2.0 million (Minimum Loan Amount), with 60 days notice. Atlantic can demand payment of the Minimum Loan Amount with 90 days notice. Under the Atlantic Loan agreement, we can require Atlantic to loan us (1) up to $2.0 million to repay an amount due from CBTM to Unicorn, a related party to NaviSite and Atlantic; (2) $1.0 million for costs associated with our acquisition of Avasta; and (3) up to $500,000 for the post-acquisition working capital needs of Avasta. Atlantic, at its sole and absolute discretion, may advance other amounts to us such that the aggregate amount borrowed by NaviSite does not exceed the maximum loan amount, defined as the lesser of $10.0 million or 65% of our consolidated accounts receivables. On May 30, 2003, we repaid $2.0 million of the approximate $3.0 million outstanding under the Atlantic Loan and on June 11, 2003, we borrowed $2.0 million under the Atlantic Loan. At April 30, 2004, we had $3.0 million outstanding under the Atlantic Loan. This amount is shown as Current Note Payable to Related Party on our Consolidated

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Balance Sheet. The Atlantic Loan is secured by all of our receivables and is subordinated to the borrowings from Silicon Valley Bank.

      On January 16, 2004, the Atlantic Loan was amended to extend any and all Credit Advances under the Atlantic Loan made prior to or following, January 16, 2004, to be due on or before the earlier of (i) August 1, 2004 or (ii) five (5) business days following the closing of a financing transaction or disposition pursuant to which the Borrower receives gross proceeds of $13 million.

 
     (c) Note Payable to AppliedTheory Estate

      As part of CBTM’s acquisition of certain AppliedTheory assets, CBTM entered into two unsecured promissory notes totaling $6.0 million (Estate Liability) due to the AppliedTheory Estate on June 10, 2006. The Estate Liability bears interest at 8% per annum, which is due and payable annually. At April 30, 2004, we had approximately $440,000 in accrued interest related to this note, which is reflected within accrued expenses on our Consolidated Balance Sheet.

 
     (d) Notes Payable to the Interliant Estate

      As part of our acquisition of certain Interliant Assets, we entered into a promissory note with the Interliant Estate (Interliant Promissory Note) in the amount of $550,000, payable without interest on the earlier of (i) the 180th day following the Second Closing Date or (ii) the date Interliant Estate makes distributions to their general unsecured creditors. The Interliant Promissory Note was secured by the Interliant Notes and the accounts receivable acquired as part of the Interliant Assets. Pursuant to the terms of the Asset Purchase Agreement between Intrepid and Interliant, each party placed $300,000 in escrow as security for adjustments in the purchase price based upon changes in Interliant’s net worth at the time of the closing. On March 8, 2004, the court approved the $325,000 net worth adjustment in favor of Intrepid and we adjusted our purchase accounting to reflect this resolution by reducing intangible assets. In conjunction with this resolution, Intrepid’s $550,000 promissory note in favor of Interliant was satisfied out of the net worth adjustment and the remaining balance of $225,000 was paid from funds Intrepid had placed in escrow and Interliant’s security interest securing Intrepid’s obligations under the Interliant Promissory Note was released.

 
     (e) Notes Payable to Landlord

      As part of an amendment to our 400 Minuteman Road lease, $2.2 million of our future payments to the landlord of our 400 Minuteman Road facility were transferred into a note payable (Landlord Note). The Landlord Note bears interest at an annual rate of 11% and calls for 36 equal monthly payments of principal and interest, with the final payment due on November 1, 2006. The $2.2 million represents leasehold improvements made by the landlord, on our behalf, to the 400 Minuteman location in order to facilitate the leasing of a portion of the facility (First Lease Amendment), as well as common area maintenance and property taxes associated with the space.

      In addition, during the three months ended January 31, 2004, we paid $120,000 and we entered into a separate $150,000 note (Second Landlord Note) with the landlord for additional leasehold improvements to facilitate a subleasing transaction involving a specific section of the 400 Minuteman location. The Second Landlord Note bears interest at an annual rate of 11% and calls for 36 equal monthly payments of principal and interest, with the final payment due on March 1, 2007.

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10. Commitments and Contingencies
 
     (a) Leases
 
Abandoned Leased Facilities

      On January 31, 2003, we abandoned our administrative space on the second floor of our 400 Minuteman Road, Andover, MA leased location. We continue to maintain and operate our Data Center on the first floor of the building. While we remain obligated under the terms of the lease for the rent and other costs associated with the second floor of the building, we ceased to use the space on January 31, 2003. Therefore, in accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” issued in July 2002, we recorded a charge to our earnings in fiscal year 2003 of approximately $5.4 million to recognize the costs of exiting the space. The liability is equal to the total amount of rent and other direct costs for the period of time the second floor of the building was expected to remain unoccupied plus the present value of the amount by which the rent paid by us to the landlord exceeds any rent paid to us by a tenant under a sublease over the remainder of the lease term, which is May 2011. During the second quarter of fiscal 2004, $2.2 million of our future payments to the landlord of our 400 Minuteman Road facility were transferred into a note payable (see Note 9(e)).

      Near the end of our fiscal year 2002, we abandoned our sales office space in La Jolla, CA. At that time we were able to sublet the space to a third party. During the second quarter of fiscal year 2003, the sublease tenant stopped making payments under the sublease and has abandoned the space. The facility is currently empty and we remain obligated under the terms of the lease for the rent and other costs associated with the building. We have no foreseeable plans to occupy the space; therefore, under SFAS No. 146, we recorded a charge to our earnings of approximately $1.4 million during fiscal year 2003 to recognize the costs of exiting the building.

      In conjunction with the Conxion acquisition in April 2003, we impaired data center and office leases in Chicago, IL, Herndon, VA, and Amsterdam, as these leases provided no economic benefit to the combined company.

      In October 2003, we abandoned administrative office space at 55 Francisco St., San Francisco, CA and data center space and office space located at Westwood Center, Vienna, VA. While we remain obligated under the terms of these leases for the rent and other costs associated with these leases, we made the decision to cease using these spaces on October 31, 2003 and have no foreseeable plans to occupy them in the future. Therefore, in accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” issued in July 2002, we recorded a charge to our current earnings in the first quarter of fiscal year 2004 of approximately $1.1 million to recognize the costs of exiting the space. The amount is included in the caption “Impairment, restructuring and other” in the accompanying Consolidated Statements of Operations. The liability is equal to the total amount of rent and other direct costs for the period of time space is expected to remain unoccupied plus the present value of the amount by which the rent paid by us to the landlord exceeds any rent paid to us by a tenant under a sublease over the remainder of the lease terms, which expire in January 2006 for San Francisco, CA and July 2005 for Vienna, VA, respectively.

      The $206,000 net impairment charge recorded during the three months ended April 30, 2004 resulted from the write-off of $300,000 in property and equipment, net of $94,000 in recovery of impairment charges, triggered by the termination and settlement of the abandoned lease at 55 Francisco, San Francisco, CA. Additional net adjustments of $69,000 were recorded during the three months ended April 30, 2004, in conjunction with the final purchase accounting for Conxion.

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      Details of activity in the lease exit accrual for the three months ended April 30, 2004 were as follows (in thousands):

                                 
Balance at Payments, less Balance at
January 31, Accretion of April 30,
2004 Interest Adjustments 2004




400 Minuteman lease abandonment costs
  $ 1,267     $ (124 )   $     $ 1,143  
La Jolla lease abandonment costs
    1,060       (175 )           885  
Chicago & Virginia lease abandonment costs
    1,407       (220 )     (73 )     1,114  
Amsterdam lease abandonment costs
    100       4       142       246  
Vienna lease abandonment costs
    551       (175 )           376  
55 Francisco lease abandonment costs
    457       (60 )     (94 )     303  
     
     
     
     
 
    $ 4,842     $ (750 )   $ (25 )   $ 4,067  
     
     
     
     
 

      We are obligated under various capital and operating leases for facilities and equipment.

      Minimum annual rental commitments under operating leases and other commitments are as follows as of April 30, 2004 (in thousands):

                                                         
Less than After
Description Total 1 Year Year 2 Year 3 Year 4 Year 5 5 Years








Short/Long-term debt
  $ 27,400     $ 20,048     $ 815     $ 6,537     $     $     $  
Interest on debt
    1,819       859       480       480                    
Capital leases
    3,248       2,418       830                          
Operating leases
    535       523       12                          
Bandwidth commitments
    7,981       3,095       2,768       1,875       243              —  
Maintenance for hardware/ software
    1,019       1,019                                
Property leases
    57,808       12,599       11,184       8,804       8,655       7,014       9,552  
     
     
     
     
     
     
     
 
    $ 99,810     $ 40,561     $ 16,089     $ 17,696     $ 8,898     $ 7,014     $ 9,552  
     
     
     
     
     
     
     
 

      On June 10, 2004, we completed the acquisition of substantially all of the assets and liabilities of Surebridge. Under the terms of the Asset Purchase Agreement, we issued two promissory notes in the aggregate principal amount of approximately $39.3 million to Surebridge. The Notes accrue interest on the unpaid balance at an annual rate of 10%, however no interest shall accrue on any principal paid within nine months of the closing. The Notes shall be paid in full no later than the second anniversary of the closing. In the event that we realize net proceeds in excess of $1 million from certain equity or debt financings or sales of assets, we are obligated to use a significant portion of the proceeds to make payments on the Notes. The outstanding principal and accrued interest of the Notes shall be convertible into shares of NaviSite common stock (the “Conversion Shares”) at the election of the holder (i) at any time following the first anniversary of the closing if the aggregate principal outstanding under the Notes at such time is greater than or equal to $20 million, (ii) at any time following the 18-month anniversary of the closing if the aggregate principal outstanding under the Notes at such time is greater than or equal to $10 million, (iii) at any time following the second anniversary of the closing, and (iv) at any time following an event of default thereunder. The conversion price of each of the Notes is $4.642, which is the average closing price of NaviSite’s common stock for the ten-day period ending one day prior to closing.

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     (b) Legal Matters
 
IPO Securities Litigation

      On or about June 13, 2001, Stuart Werman and Lynn McFarlane filed a lawsuit against us, BancBoston Robertson Stephens, an underwriter of our initial public offering in October 1999, Joel B. Rosen, our then chief executive officer, and Kenneth W. Hale, our then chief financial officer. The suit was filed in the United States District Court for the Southern District of New York. The suit generally alleges that the defendants violated federal securities laws by not disclosing certain actions allegedly taken by Robertson Stephens in connection with our initial public offering. The suit alleges specifically that Robertson Stephens, in exchange for the allocation to its customers of shares of our common stock sold in our initial public offering, solicited and received from its customers’ agreements to purchase additional shares of our common stock in the aftermarket at pre-determined prices. The suit seeks unspecified monetary damages and certification of a plaintiff class consisting of all persons who acquired shares of our common stock between October 22, 1999 and December 6, 2000. Three other substantially similar lawsuits were filed between June 15, 2001 and July 10, 2001 by Moses Mayer (filed June 15, 2001), Barry Feldman (filed June 19, 2001), and Binh Nguyen (filed July 10, 2001). Robert E. Eisenberg, our president at the time of the initial public offering in 1999, also was named as a defendant in the Nguyen lawsuit.

      On or about June 21, 2001, David Federico filed in the United States District Court for the Southern District of New York a lawsuit against us, Mr. Rosen, Mr. Hale, Robertson Stephens and other underwriter defendants including J.P. Morgan Chase, First Albany Companies, Inc., Bank of America Securities, LLC, Bear Stearns & Co., Inc., B.T. Alex. Brown, Inc., Chase Securities, Inc., CIBC World Markets, Credit Suisse First Boston Corp., Dain Rauscher, Inc., Deutsche Bank Securities, Inc., The Goldman Sachs Group, Inc., J.P. Morgan & Co., J.P. Morgan Securities, Lehman Brothers, Inc., Merrill Lynch, Pierce, Fenner & Smith, Inc., Morgan Stanley Dean Witter & Co., Robert Fleming, Inc. and Salomon Smith Barney, Inc. The suit generally alleges that the defendants violated the anti-trust laws and the federal securities laws by conspiring and agreeing to raise and increase the compensation received by the underwriter defendants by requiring those who received allocation of initial public offering stock to agree to purchase shares of manipulated securities in the after-market of the initial public offering at escalating price levels designed to inflate the price of the manipulated stock, thus artificially creating an appearance of demand and high prices for that stock, and initial public offering stock in general, leading to further stock offerings. The suit also alleges that the defendants arranged for the underwriter defendants to receive undisclosed and excessive brokerage commissions and that, as a consequence, the underwriter defendants successfully increased investor interest in the manipulated initial public offering of securities and increased the underwriter defendants’ individual and collective underwritings, compensation, and revenue. The suit further alleges that the defendants violated the federal securities laws by issuing and selling securities pursuant to the initial public offering without disclosing to investors that the underwriter defendants in the offering, including the lead underwriters, had solicited and received excessive and undisclosed commissions from certain investors. The suit seeks unspecified monetary damages and certification of a plaintiff class consisting of all persons who acquired shares of our common stock between October 22, 1999 and June 12, 2001.

      Those five cases, along with lawsuits naming more than 300 other issuers and over 50 investment banks, which have been sued in substantially similar lawsuits, have been assigned to the Honorable Shira A. Scheindlin (the “Court”) for all pretrial purposes (the “IPO Securities Litigation”). On September 6, 2001, the Court entered an order consolidating the five individual cases involving us and designating Werman v. NaviSite, Inc., et al., Civil Action No. 01-CV-5374 as the lead case. A consolidated, amended complaint was filed thereafter on April 19, 2002 (the “Class Action Litigation”) on behalf of plaintiffs Arvid Brandstrom and Tony Tse against underwriter defendants Robertson Stephens (as

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successor-in-interest to BancBoston), BancBoston, J.P. Morgan (as successor-in-interest to Hambrecht & Quist), Hambrecht & Quist and First Albany and against us and Messrs. Rosen, Hale and Eisenberg (collectively, the “NaviSite Defendants”). Plaintiffs uniformly allege that all defendants, including the NaviSite Defendants, violated the federal securities laws (i.e., Sections 11 and 15 of the Securities Act, Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5) by issuing and selling our common stock pursuant to the October 22, 1999, initial public offering, without disclosing to investors that some of the underwriters of the offering, including the lead underwriters, had solicited and received extensive and undisclosed agreements from certain investors to purchase aftermarket shares at pre-arranged, escalating prices and also to receive additional commissions and/or other compensation from those investors. At this time, plaintiffs have not specified the amount of damages they are seeking in the Class Action Litigation.

      Between July and September 2002, the parties to the IPO Securities Litigation briefed motions to dismiss filed by the underwriter defendants and the issuer defendants, including NaviSite. On November 1, 2002, the Court held oral argument on the motions to dismiss. The plaintiffs have since agreed to dismiss the claims against Messrs. Rosen, Hale and Eisenberg without prejudice, in return for their agreement to toll any statute of limitations applicable to those claims. By stipulation entered by the Court on November 18, 2002, Messrs. Rosen, Hale and Eisenberg were dismissed without prejudice from the Class Action Litigation. On February 19, 2003, an opinion and order was issued on defendants’ motion to dismiss the IPO Securities Litigation, essentially denying the motions to dismiss of all 55 underwriter defendants and of 185 of the 301 issuer defendants, including NaviSite.

      On June 30, 2003, our Board of Directors considered and authorized us to negotiate a settlement of the pending Class Action Litigation substantially consistent with a memorandum of understanding negotiated among class plaintiffs, the issuer defendants and the insurers for such issuer defendants. On June 14, 2004, a Stipulation and Agreement of Settlement with Defendant Issuers and Individuals was submitted to the Court. The Court ordered plaintiffs to file a motion for preliminary approval on or before June 25, 2004, and the motion is expected to be fully briefed by July 21, 2004. If completed and then given final approval by the Court, the settlement is expected to be covered by our existing insurance policies and is not expected to have a material effect on our business or financial results.

      We believe that the allegations against us are without merit and, if the settlement is not finalized, we intend to vigorously defend against the plaintiffs’ claims. Due to the inherent uncertainty of litigation, we are not able to predict the possible outcome of the suits and their ultimate effect, if any, on our financial condition.

 
Goldman Sachs Payment Demand

      In March 2001, we engaged Goldman Sachs & Co. to serve as our financial advisor in connection with the possible sale of all or a portion of NaviSite. On September 17, 2002, Goldman made a written demand for payment of a $3.0 million success fee in connection with the September 2002 acquisition by CBT of the stock and convertible debt of NaviSite from CMGI and Hewlett-Packard Financial Services Company. We have rejected Goldman’s demands, as we believe they are without merit. No legal actions have been filed concerning the Goldman claim. As this matter is in the initial stage, we are not able to predict the possible outcome of this matter and the effect, if any, on our financial condition.

 
Joseph Cloonan

      On or about September 27, 2002, we received a demand for a wage payment of $850,000 from our former Procurement Director, Joseph Cloonan. We rejected the demand, alleging that Mr. Cloonan’s claim is based, among other things, on a potentially fraudulent contract. Mr. Cloonan also claimed $40,300 for allegedly unpaid accrued vacation and bonuses and that he may be statutorily entitled to treble damages and legal fees. On October 11, 2002, NaviSite filed a civil complaint with the Massachusetts Superior

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Court, Essex County, seeking a declaratory judgment and asserting claims against Mr. Cloonan for civil fraud, misrepresentation, unjust enrichment and breach of duty of loyalty. Mr. Cloonan asserted counter claims against NaviSite seeking the payments set forth in his September 2002 demand. We believe Mr. Cloonan’s allegations are without merit and intend to vigorously defend against them. As the litigation is in the discovery stage, we are not able to predict the possible outcome of this matter and the effect, if any, on our financial condition.

 
Lighthouse International

      On October 28, 2002, CBTM, one of our subsidiaries, filed a complaint in United States District Court for the Southern District of New York against Lighthouse International, alleging six causes of action for copyright infringement, breach of contract, account stated, unjust enrichment, unfair competition, and misappropriation and/or conversion. The total claimed damages are in the amount of $1.9 million. On or about January 16, 2003, Lighthouse filed and served its answer and counterclaimed against CBTM claiming $3.1 million in damages and $5.0 million in punitive relief.

      On June 17, 2003, the U.S. Bankruptcy Court for the Southern District of New York heard oral argument on Lighthouse’s Motion for an Order Compelling the Debtor (AppliedTheory) to Assume or Reject an Agreement, filed in response to CBTM’s complaint, and the objections to Lighthouse’s motion filed by CBTM and AppliedTheory. Lighthouse made this motion on the basis that it never received notice of CBTM assuming the AppliedTheory contract for the LighthouseLink Web site. The Bankruptcy Court declined to grant Lighthouse’s motion, and instead ordered that an evidentiary hearing be conducted to determine whether Lighthouse received appropriate notice of the proposed assignment of the contract by AppliedTheory to CBTM. The Bankruptcy Court ordered that the parties first conduct discovery, and upon completion of discovery, the Bankruptcy Court would schedule an evidentiary hearing on the issues of due process and notice.

      As to the U.S. District Court matter, the exchange of written discovery has been completed. Further, the majority of depositions of witnesses have been completed. Factual discovery has been completed, with expert discovery to be exchanged by the end of August 2004. On June 15, 2004, District Court Judge Pauley determined that both parties could proceed with their respective summary judgment motions. All motion papers shall be finally submitted by September 20, 2004, with oral argument scheduled for October 15, 2004. In the interim, expert discovery shall be completed by the parties. A final pre-trial conference is scheduled for October 15, 2004. Because of the pending motion requests, the future expert discovery to be completed, and the uncertain outcome of the evidentiary hearing before the Bankruptcy Court, we are not able to predict the possible outcome of this matter, if any, on our financial condition.

 
Avasta Earnout

      On October 14, 2003, we received a letter purportedly on behalf of the former stockholders of Avasta relating to the issuance of additional shares of common stock pursuant to the earnout calculations pursuant to the Agreement and Plan of Merger and Reorganization dated as of January 29, 2003 among Avasta Corp., Avasta, Inc. and NaviSite. On December 11, 2003, a demand for arbitration before JAMS (formerly known as Judicial Arbitration and Mediation Services) was filed claiming among other things breach of contract, tortious conduct, fraud and other wrongful conduct. Damages sought include in excess of 782,790 shares of NaviSite common stock. We believe the allegations are without merit and intend to vigorously defend against them. As the arbitration is in the initial discovery stage, we are not able to predict the possible outcome of this matter and the effect, if any, on our financial condition.

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La Jolla Landlord

      On November 24, 2003, U.S. Property Fund GmbH & Co, the landlord for space leased by NaviSite in La Jolla, California, filed a breach of lease action against NaviSite. The landlord claims damages in excess of $2.0 million. On February 23, 2004, the landlord agreed to stay the litigation in exchange for NaviSite agreeing to make future rent payments in a timely manner and replenishing the letter of credit within 12 months.