Edgar Filing: DIGITAL IMPACT INC /DE/

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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FORM 10-Q
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(Mark one)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2001

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM TO

COMMISSION FILE NUMBER: 000-27787

DIGITAL IMPACT, INC.
(Exact name of registrant as specified in its charter)

DELAWARE 94-3286913
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

177 BOVET ROAD
SAN MATEO, CALIFORNIA 94402
(Address of principal executive offices)

TELEPHONE NUMBER (650) 356-3400
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days: Yes [X] No [ ]

As of November 9, 2001, there were approximately 28,719,000 shares of the
Registrant's Common Stock outstanding.
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DIGITAL IMPACT, INC.

INDEX

PAGE
NO.
--------

PART I. FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS:
Condensed Consolidated Statements of Operations for the
three and six months ended September 30, 2001 and 2000...... 2
Consolidated Balance Sheets as of September 30, 2001 and
March 31, 2001.............................................. 3
Condensed Consolidated Statements of Cash Flows for the six
months ended September 30, 2001 and 2000.................... 4
Notes to Condensed Consolidated Financial Statements........ 5
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS................................... 10
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK........................................................ 15

PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS........................................... 19
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS................... 20
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS......... 20
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K............................ 21
SIGNATURES.................................................. 22

PART I. FINANCIAL INFORMATION

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

DIGITAL IMPACT, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)

THREE MONTHS ENDED SIX MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------ -------------------
2001 2000 2001 2000
------- -------- -------- --------

Revenues............................................ $ 8,420 $ 9,371 $ 18,426 $ 17,845
Cost of revenues.................................... 4,212 4,154 8,772 7,867
------- -------- -------- --------
Gross margin........................................ 4,208 5,217 9,654 9,978
Operating expenses:
Research and development.......................... 3,032 4,640 6,723 7,866
Sales and marketing............................... 4,389 3,926 8,904 8,150
General and administrative........................ 2,288 2,767 4,618 5,067
Stock-based compensation.......................... 816 1,723 2,150 3,758
Amortization of goodwill and purchased
intangibles.................................... 375 1,607 750 1,607
Write-off of acquired in-process research and
development and fixed assets................... -- 4,563 -- 4,563
------- -------- -------- --------
Total operating expenses............................ 10,900 19,226 23,145 31,011
------- -------- -------- --------
Loss from operations................................ (6,692) (14,009) (13,491) (21,033)
Interest income, net................................ 141 868 325 1,836
------- -------- -------- --------
Net loss............................................ $(6,551) $(13,141) $(13,166) $(19,197)
======= ======== ======== ========
Net loss per common share -- basic and diluted...... $ (0.24) $ (0.55) $ (0.48) $ (0.83)
======= ======== ======== ========
Shares used in net loss per common share
calculation -- basic and diluted.................. 27,610 24,010 27,340 23,090
======= ======== ======== ========

The accompanying notes are an integral part of these unaudited
condensed consolidated financial statements.
2

DIGITAL IMPACT, INC.

CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
(UNAUDITED)

SEPTEMBER 30, MARCH 31,
2001 2001
------------- ---------

ASSETS
Current assets:
Cash and cash equivalents.............................. $28,036 $35,038
Accounts receivable, net............................... 8,138 12,899
Prepaid expenses and other current assets.............. 814 551
------- -------
Total current assets.............................. 36,988 48,488
------- -------
Property and equipment, net................................. 12,223 13,100
Restricted cash............................................. 1,932 1,847
Intangible assets........................................... 3,932 5,005
Other assets................................................ 494 579
------- -------
Total assets...................................... $55,569 $69,019
======= =======

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable....................................... $ 2,399 $ 4,557
Deferred revenues...................................... 1,269 1,050
Accrued payroll........................................ 2,114 2,342
Accrued liabilities.................................... 977 1,087
Current portion of capital lease obligations........... 817 862
Current portion of long term debt...................... 1,359 913
------- -------
Total current liabilities......................... 8,935 10,811
------- -------
Capital lease obligations, less current portion............. 106 524
Long term debt, less current portion........................ 1,893 2,129
------- -------
Total liabilities................................. 10,934 13,464
------- -------
Stockholders' equity:
Common Stock........................................... 27 27
Additional paid-in capital............................. 142,657 141,823
Accumulated other comprehensive loss................... (34) (34)
Unearned stock-based compensation...................... (2,766) (4,387)
Accumulated deficit.................................... (94,893) (81,727)
Less treasury stock at cost............................ $ (356) (147)
------- -------
Total stockholders' equity........................ 44,635 55,555
------- -------
Total liabilities and stockholders' equity........ $55,569 $69,019
======= =======

The accompanying notes are an integral part of these
unaudited condensed consolidated financial statements.
3

DIGITAL IMPACT, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)

SIX MONTHS ENDED
SEPTEMBER 30,
-------------------
2001 2000
-------- --------

Cash flows from operating activities
Net loss.................................................. $(13,166) $(19,197)
Adjustments to reconcile net loss to net cash provided by
operating activities:
Charge for acquired in-process research and development
and fixed assets...................................... -- 4,563
Depreciation and amortization.......................... 3,830 3,419
Provision for (recovery of) bad debts.................. (209) 600
Amortization of unearned stock-based compensation...... 2,150 3,758
Changes in operating assets and liabilities:
Accounts receivable.................................. 4,970 (4,105)
Prepaid expenses and other current assets............ (263) 128
Restricted cash...................................... (85) (1,739)
Other assets......................................... 85 (317)
Accounts payable..................................... (2,158) 628
Accrued liabilities and deferred revenue............. (119) 351
-------- --------
Net cash used in operating activities....................... (4,965) (11,911)
-------- --------
Cash flows from investing activities
Acquisition of property and equipment..................... (1,257) (5,107)
Cash acquired from acquisition............................ -- 264
-------- --------
Net cash used in investing activities....................... (1,257) (4,843)
-------- --------
Cash flows from financing activities
Principal payments on long-term debt...................... (876) (395)
Proceeds from exercise of common stock options and
warrants, net of treasury stock repurchase............. 96 1,016
-------- --------
Net cash (used in) provided by financing activities......... (780) 621
-------- --------
Net decrease in cash and cash equivalents................... (7,002) (16,133)
Cash and cash equivalents at beginning of period............ 35,038 68,073
-------- --------
Cash and cash equivalents at end of period.................. $ 28,036 $ 51,940
======== ========
Supplemental noncash information:
Fair value of net assets acquired (excluding transaction
costs)................................................. $ -- $ 31,145
Assets acquired under capital leases...................... $ 623 $ 140
Unearned stock-based compensation......................... $ 529 $ (349)

The accompanying notes are an integral part of these unaudited
condensed consolidated financial statements.
4

DIGITAL IMPACT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. THE COMPANY

Digital Impact, Inc. ("Digital Impact" or the "Company") is one of the
premier providers of online direct marketing solutions for enterprises. The
Company was incorporated in California in October 1997 and reincorporated in
Delaware in October 1999. Digital Impact's solutions -- Strategy, Customer
Acquisition and Customer Marketing -- enable corporations to create and deliver
marketing programs that drive revenue, influence behavior and deepen customer
relationships. Digital Impact solutions provide deeper customer insight and
powerful program execution through a combination of hosted web applications,
messaging technology infrastructure and professional services.

NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

BASIS OF PRESENTATION AND LIQUIDITY

The accompanying interim consolidated financial statements are unaudited,
but in the opinion of management, contain all the adjustments (consisting of
those of a normal, recurring nature) considered necessary to present fairly the
financial position, results of operations and cash flows for the periods
presented in conformity with generally accepted accounting principles applicable
to interim periods. Certain information and footnote disclosures normally
included in financial statements prepared in accordance with generally accepted
accounting principles have been condensed or omitted under the Securities and
Exchange Commission's ("SEC") rules and regulations. Results of operations are
not necessarily indicative of the results expected for the full fiscal year or
any other future period.

The accompanying interim condensed consolidated financial statements should
be read in conjunction with the audited financial statements and the notes
thereto included in Digital Impact's Annual Report on Form 10-K for the fiscal
year ended March 31, 2001.

The Company has incurred recurring losses from operations and has an
accumulated deficit of approximately $94.9 million as of September 30, 2001. The
Company has incurred substantial losses and negative cash flows from operations
since inception. For the six months ended September 30, 2001, the Company
incurred a loss from operations of approximately $13.5 million and negative cash
flows from operations of approximately $5.0 million. Management expects
operating losses and negative cash flows to continue for the next several
quarters and anticipates that losses will decrease from its historic levels due
to a reduction of costs and expenses related to its workforce following the 10%
reduction in force in September, consultants and other discretionary spending
and an increase in its customer revenues and expansion of product offerings and
development of relationships with other businesses. Failure to generate
sufficient revenues, raise additional capital or reduce certain discretionary
spending could have a material adverse effect on the Company's ability to
achieve its intended business objectives.

The Company believes it has sufficient cash and cash equivalents to fund
operations for the next twelve months.

PRINCIPLES OF CONSOLIDATION

The accompanying interim consolidated financial statements include the
accounts of Digital Impact, Inc. and its wholly owned subsidiaries. All
significant intercompany transactions and balances have been eliminated on
consolidation.

COMPREHENSIVE INCOME

Comprehensive income is defined as the change in equity of a business
enterprise during a period from transactions and other events and circumstances
from non-owner sources. Other comprehensive loss, a component of stockholders'
equity, recorded by the Company for the six months ended September 30, 2001

DIGITAL IMPACT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

was attributable to an unrealized loss on cash equivalents. The Company did not
have any additional transactions that were required to be reported in other
comprehensive income during the six months ended September 30, 2001.

CONCENTRATION OF CREDIT RISK AND OTHER RISKS AND UNCERTAINTIES

Financial instruments subjecting the Company to concentration of credit
risk consist primarily of cash and cash equivalents and trade accounts
receivable. The Company's cash and cash equivalents are maintained at a major
U.S. financial institution. Deposits in this institution may exceed the amount
of insurance provided on such deposits.

The Company's customers are primarily concentrated in the United States.
The Company performs ongoing credit evaluations and establishes an allowance for
doubtful accounts based upon factors surrounding the credit risk of customers,
historical trends and other information.

NOTE 3. RECENT ACCOUNTING PRONOUNCEMENTS

In June 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 133, or SFAS 133, "Accounting
for Derivative Instruments and Hedging Activities." SFAS 133 establishes new
standards of accounting and reporting for derivative instruments and hedging
activities. SFAS 133 requires that all derivatives be recognized at fair value
in the statement of financial position, and that the corresponding gains or
losses be reported either in the statement of operations or as a component of
comprehensive income, depending on the type of hedging relationship that exists.
In July 1999, the FASB issued SFAS 137, "Accounting for Derivative Instruments
and Hedging Activities -- Deferral of the Effective Date of SAFAS 133". SFAS 137
deferred the date of SFAS 133 until the first fiscal year beginning after June
15, 2001. In June 2000, the FASB issued SFAS 138, "Accounting for Certain
Derivative Instruments and Certain Hedging Activities -- an Amendment of SFAS
133." SFAS 138 amends SFAS 133 to permit limited use of central treasury
offsetting of net exposures of intercompany derivatives for foreign currency
cash flow hedges. SFAS 138 must be adopted concurrently with SFAS 133. The
Company does not currently hold derivative instruments or engage in hedging
activities and hence the implementation of SFAS 133 did not have a material
impact upon the financial statements of the Company.

In July 2001, the Financial Accounting Standards Board issued SFAS No. 141
"Business Combinations," which established financial accounting and reporting
for business combinations and superseded APB Opinion No. 16, Business
Combinations, and FASB Statement No. 38, Accounting for Preacquisition
Contingencies of Purchased Enterprises. It requires that all business
combinations in the scope of this Statement are to be accounted for using one
method, the purchase method. The provisions of this Statement apply to all
business combinations initiated after June 30, 2001, and also apply to all
business combinations accounted for using the purchase method for which the date
of acquisition is July 1, 2001, or later.

In July 2001, the Financial Accounting Standards Board issued SFAS No. 142
"Goodwill and Other Intangible Assets," which established financial accounting
and reporting for acquired goodwill and other intangible assets and supersedes
APB Opinion No. 17, Intangible Assets. It addresses how intangible assets that
are acquired individually or with a group of other assets (but not those
acquired in a business combination) should be accounted for in financial
statements upon their acquisition and after they have been initially recognized
in the financial statements. The provisions of this Statement are effective
starting with fiscal years beginning after December 15, 2001. Early adoption is
permitted for entities with fiscal years beginning after March 15, 2001,
provided that the first interim financial statements have not previously been
issued. Accordingly, the Company has elected not to early adopt SFAS No. 142
beginning with the first quarter of fiscal 2002. Upon adoption of FAS 142, the
Company will reclassify the amount relating to assembled workforce (currently
$1.6 million) from intangible assets to goodwill and will no longer amortize
goodwill.
6

DIGITAL IMPACT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

On October 3, 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." SFAS No. 144 supercedes SFAS No.
121 "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of." SFAS No. 144 applies to all long-lived assets
(including discontinued operations) and consequently amends APB Opinion No. 30,
"Reporting the Results of Operations, Reporting the Effects of Disposal of a
Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions." SFAS No. 144 develops one accounting model for long-
lived assets that are to be disposed of by sale. SFAS No. 144 requires that
long-lived assets that are to be disposed of by sale be measured at the lower of
book value or fair value less cost to sell. Additionally SFAS No. 144 expands
the scope of discontinued operations to include all components of an entity with
operations that (1) can be distinguished from the rest of the entity and (2)
will be eliminated from the ongoing operations of the entity in a disposal
transaction. SFAS No. 144 is effective for the Company for all financial
statements issued in 2002. The adoption of SFAS No. 144 is not expected to have
a material impact on the Company's financial statements.

NOTE 4. NET LOSS PER SHARE

Basic net loss per share is computed using the weighted-average number of
outstanding shares of common stock, excluding common stock subject to
repurchase. Diluted net loss per share is computed using the weighted-average
number of outstanding shares of common stock and, when dilutive, potential
common shares from options and warrants to purchase common stock and common
stock subject to repurchase using the treasury stock method. The following table
presents the calculation of basic and diluted net loss per share:

THREE MONTHS ENDED SIX MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------ -------------------
2001 2000 2001 2000
------- -------- -------- --------

Numerator:
Net loss............................................ $(6,551) $(13,141) $(13,166) $(19,197)
======= ======== ======== ========
Denominator:
Weighted average common shares outstanding........ 28,060 26,030 27,980 25,330
Weighted average unvested common shares subject to
repurchase..................................... (450) (2,020) (641) (2,240)
------- -------- -------- --------
Denominator for basic and diluted calculation....... 27,610 24,010 27,340 23,090
======= ======== ======== ========
Net loss per common share -- basic and diluted...... $ (0.24) $ (0.55) $ (0.48) $ (0.83)
======= ======== ======== ========

The following warrants, outstanding stock options, and shares subject to
repurchase by the Company have been excluded from the calculation of diluted net
loss per common share because all such securities are antidilutive for all
periods presented:

SIX MONTHS ENDED
SEPTEMBER 30,
-----------------------
2001 2000
---------- ----------

Options..................................................... 6,585,000 6,624,000
Shares...................................................... 270,042 1,810,000
Warrants.................................................... -- 38,000

NOTE 5. STOCK-BASED COMPENSATION

During the six months ended September 30, 2001, the Company reduced
unearned stock-based compensation, a component of stockholders' equity, by
approximately $1.7 million. This reduction was the

DIGITAL IMPACT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

result of amortization of stock-based compensation of approximately $2.2 million
and a reduction of approximately $823,000 related primarily to stock option
forfeitures and the revaluation of options granted to consultants, offset by the
recording of approximately $1.3 million of deferred compensation related to the
issuance of restricted stock in exchange for the cancellation of options.
Unearned stock-based compensation is amortized to expense over the period during
which the options and restricted stock vest, generally three to four years, in
accordance with FASB Interpretation No. 28.

In March 2001, the Company issued approximately 548,000 shares of
restricted stock with a fair value of $1.34 as part of a retention program
designed to retain key executives. The restricted stock was issued with a
purchase price of $0.001 with half the stock vesting on the date of issuance and
the remaining half vesting in the quarter ended September 30, 2001. As a result,
the Company recognized approximately $361,000 of compensation expense in the
fiscal year ended March 31, 2001 and $375,000 in the six months ended September
30, 2001. This amount is included in the $2.2 million of deferred compensation
reported above.

In May 2001, the Company issued approximately 797,500 shares of restricted
stock with a fair value of $1.17 in exchange for the cancellation of
approximately 737,500 options. The restricted stock was issued with a purchase
price of $0.001 with one sixth of the stock vesting on the grant date and the
remainder vesting over three years. As a result, the Company recognized
approximately $921,000 of compensation expense in the six months ended September
30, 2001 for the shares that vested immediately and the shares that vested in
the first and second quarters. The remainder of the unearned stock-based
compensation will be recognized over the period which the restricted stock vests
in accordance with FASB Interpretation No. 28.

NOTE 6. RESTRUCTURING CHARGES

In September 2001, management took additional steps to further increase
operational efficiencies and to bring costs in line with revenues. These
measures included the involuntary termination of approximately 30 employees,
approximately 10% of the Company's workforce. As a result, Digital Impact
recorded a charge of approximately $100,000 to operations for the quarter ended
September 30, 2001. As of September 30, 2001, all of the $100,000 charge had
been paid.

NOTE 7. CONTINGENCIES

On June 5, 2001, a putative securities class action, captioned Stein v.
Digital Impact, Inc., et al., Civil Action No. 01-CV-4942, was filed against
Digital Impact, two of its officers (William Park and David Oppenheimer), and
Credit Suisse First Boston Corporation ("CSFB"), an underwriter in Digital
Impact's initial public offering, in the United States District Court for the
Southern District of New York. The complaint alleges violations of Section 11 of
the Securities Act of 1933 (the "Securities Act") against all defendants, a
violation of Section 15 of the Securities Act against William Park and David
Oppenheimer, and violations of Section 12(a)(2) of the Securities Act and
Section 10(b) of the Securities Exchange Act of 1934 (and Rule 10b-5,
promulgated thereunder) against CSFB. The complaint seeks unspecified damages on
behalf of a purported class of purchasers of common stock between November 22,
1999 and December 6, 2000. On June 19, 2001, a similar complaint, captioned
Dramn v. Digital Impact et al., Civil Action No. 01-CV-5103, was filed in the
United States District Court for the Southern District of New York. The
complaint is substantially identical to the Stein complaint: it names the same
defendants, contains virtually identical claims, and seeks unspecified damages
on behalf of a purported class of purchasers of common stock during an identical
class period.

On June 29, 2001, another similar complaint, captioned Martin v. Digital
Impact et al., Civil Action No. 01-CV-5963, was filed in the United States
District Court for the Southern District of New York. The complaint is
substantially identical to the Stein complaint: it contains virtually identical
claims and seeks unspecified damages on behalf of a purported class of
purchasers of common stock during an identical class period. In addition to the
defendants named in Stein, the Martin complaint names Gerardo Capiel, a Digital
8

DIGITAL IMPACT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Impact officer and director, as well as J.P. Morgan Chase, U.S. Bancorp Piper
Jaffray, Inc. and Bear Stearns, co-underwriters in Digital Impact's initial
public offering. The Martin complaint also alleges violations of Section 10(b)
of the Securities Exchange Act of 1934 (and Rule 10b-5 promulgated thereunder)
against Digital Impact, William Park, David Oppenheimer and Gerardo Capiel. The
Company anticipates that additional, substantially similar lawsuits may be
brought.

Various plaintiffs have filed similar actions in the United States District
Court for the Southern District of New York asserting virtually identical
allegations against more than 180 other issuers. These cases have all been
assigned to the Hon. Shira Scheindlin for coordination and decisions on pretrial
motions, discovery, and related matters other than trial. The Company believes
that it has meritorious defenses to these lawsuits and will defend itself
vigorously in the litigation. In the opinion of management, after consultation
with legal counsel and based on currently available information, the ultimate
disposition of these matters is not expected to have a material adverse effect
on our business, financial condition or results of operations, and hence no
amounts have been accrued for these cases.

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

You should read the following discussion of our financial condition and
results of operations in conjunction with our financial statements and related
notes. This discussion contains forward-looking statements that involve risks
and uncertainties. Our actual results may differ materially from those
anticipated in these forward-looking statements as a result of factors including
those discussed in "Certain Factors Which May Impact Future Operating Results,"
starting on page 15, as well as factors set forth in Digital Impact's Annual
Report on Form 10-K for the fiscal year ended March 31, 2001. Any
forward-looking statements speak only as of the date such statements are made.

OVERVIEW

Digital Impact, Inc. is one of the premier providers of online direct
marketing solutions for enterprises. We were incorporated in California in
October 1997 and reincorporated in Delaware in October 1999. Digital Impact's
solutions -- Strategy, Customer Acquisition and Customer Marketing -- enable
corporations to create and deliver marketing programs that drive revenue,
influence behavior and deepen customer relationships. Digital Impact solutions
provide deeper customer insight and powerful program execution through a
combination of hosted web applications, messaging technology infrastructure and
professional services.

In July 2000, we acquired MineShare, Inc. ("MineShare"), a customer
intelligence and analysis company based in Santa Monica, California. The
transaction was accounted for using the purchase method of accounting.

Digital Impact generates revenues from the sale of solutions that enable
businesses to proactively communicate with their customers online. Historically,
these solutions have primarily consisted of the design and execution of online
direct marketing campaigns, the development and execution of customer
acquisition programs, and additional services delivered by our professional
services organization. In accordance with Staff Accounting Bulletin No. 101,
"Revenue Recognition in Financial Statements," revenue is recognized when online
direct marketing campaigns are delivered, provided that there are no remaining
significant obligations and collection of the resulting receivable is reasonably
assured. Revenue generated from our acquisition services group, which assists
clients in growing their email lists through the use of third party list
rentals, is recognized when the campaigns are delivered, provided there are no
significant remaining obligations and the collection of receivables is
reasonably assured. The cost of renting the list is passed through to our
clients and hence is offset against the corresponding revenue. Revenue generated
from our professional services is recognized as the services are provided.

Cost of revenues consists primarily of expenses relating to the delivery of
online direct marketing services, including personnel costs, primarily
consisting of our production services and customer service staff, the
amortization of equipment, purchased and licensed technology, and data center
expenses.

Our operating expenses are classified into three general categories:
research and development, sales and marketing, and general and administrative.
We classify all charges to these operating expense categories based on the
nature of the expenditures. Although each category includes expenses that are
unique to the category, some expenditures, such as compensation, employee
benefits, recruiting costs, equipment costs, travel and entertainment costs,
facilities costs and third-party professional service fees, occur in each of
these categories.

We allocate the total cost for information services and facilities to each
functional area that uses the information services and facilities based on its
relative headcount. These allocated charges include rent and other
facility-related costs, communication charges and depreciation expense for
furniture and equipment.

Total operating expenses also include non-cash expenses related to
stock-based compensation and amortization of goodwill and purchased intangibles.

As of September 30, 2001 we had 304 full-time employees. In April and
September 2001 we realigned our organization with a workforce reduction of
approximately 60 and 30 employees, respectively, in order to streamline
operations, reduce costs and bring our staffing structure in line with current
economic conditions. As a result, costs associated with the April workforce
reduction, including severance and other employee-

related costs, were accrued in the balance sheet for the fiscal year ended March
31, 2001. Expenses related to the September work force reduction, including
severance and other employee expenses, were expensed in the quarter ended
September 30, 2001.

RESULTS OF OPERATIONS

The following table sets forth selected data for the periods indicated as a
percentage of total revenues. These operating results are not necessarily
indicative of results for any future periods.

THREE MONTHS SIX MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------- --------------
2001 2000 2001 2000
----- ----- ----- -----

Net revenue................................................. 100% 100% 100% 100%
Cost of revenue............................................. 50% 44% 48% 44%
--- ---- --- ----
Gross margin................................................ 50% 56% 52% 56%
Operating expenses:
Research and development............................... 36% 50% 36% 44%
Sales and marketing.................................... 52% 42% 48% 46%
General and administrative............................. 27% 29% 25% 28%
Stock-based compensation............................... 10% 18% 12% 21%
Amortization of goodwill and purchased intangibles..... 4% 17% 4% 9%
Nonrecurring charges................................... -- 49% -- 26%
--- ---- --- ----
Total operating expenses.......................... 129% 205% 125% 174%
Loss from operations........................................ (79)% (149)% (73)% (118)%
=== ==== === ====
Interest income, net........................................ 2% 9% 2% 10%
--- ---- --- ----
Net loss.......................................... (77)% (140)% (71)% (108)%
=== ==== === ====

THREE MONTHS ENDED SEPTEMBER 30, 2001 AND 2000

Revenues. Total revenues decreased 10% to $8.4 million for the three
months ended September 30, 2001 from $9.4 million for the three months ended
September 30, 2000. The decrease was primarily due to a decline in clients and
spending from certain continuing clients from September 2000 through September
2001 as well a temporary decline in email volume related to the events of
September 11th, partially offset by increased message volume and revenue from
other continuing clients, and the expansion of our core service offerings.

Cost of Revenues. Total cost of revenues were flat at $4.2 million for the
three months ending September 30, 2000 and 2001. Gross margins declined to 50%
for the quarter ended September 30, 2001 from 56% for the quarter ended
September 30, 2000, largely due to continued investment in our data center
infrastructure, resulting in excess capacity that when spread over our revenue
base resulted in slightly lower margins.

Research and Development. Research and development expenses consist
primarily of personnel and related costs, consultants and outside contractor
costs, and software and hardware maintenance costs for our development efforts.
To date, all research and development costs have been expensed as incurred.
Research and development expenses declined by 35% to $3.0 million for the
quarter ended September 30, 2001 from $4.6 million for the quarter ended
September 30, 2000. The decline is primarily a result of a decrease in personnel
costs of approximately $1.1 million, largely related to the decrease in
engineering staff related to our April and September realignment initiatives,
and a $900,000 reduction in outside consulting expenses related to continuing
efforts to meet development needs with internal resources, offset by a $161,000
increase in amortized tangible purchased technology expense related to our
MineShare acquisition. We expect to continue to make investments in research and
development.

Sales and Marketing. Sales and marketing expenses consist of personnel and
related costs primarily for our direct sales force and marketing staff, as well
as marketing programs, which include trade shows, advertisements, promotional
activities and media events. Sales and marketing expenses increased 12% to $4.4
million for the three months ended September 30, 2001 from $3.9 million for the
three months ended September 30, 2000. The increase was primarily due to an
increase in personnel costs of $200,000 related to expansion of our sales
organization and an increase in marketing costs of $200,000 related to expanded
advertising and promotional activities.

General and Administrative. General and administrative expenses consist
primarily of personnel and related costs for general corporate purposes,
including information services, finance, accounting, human resources, facilities
and legal. General and administrative expenses declined by 17% to $2.3 million
for the three months ended September 30, 2001 from $2.8 million for the three
months ended September 30, 2000. The overall decrease was primarily the result
of a reduction in professional service fees of $100,000, a decrease in travel
and entertainment expenses of $50,000 and a decline in bad debt expense of
$50,000.

Stock-based Compensation. In connection with the granting of stock options
to our employees and the assumption of options related to the acquisition of
MineShare, we recorded unearned stock based compensation totaling approximately
$19.1 million, net of forfeitures, from inception through September 30, 2001.
This amount represents the total difference between the exercise prices of the
stock options or purchase price of restricted stock and the deemed fair market
value of the underlying common stock for accounting purposes on the date these
stock options were granted. This amount is included as a component of
stockholders' equity and is being amortized on an accelerated basis by charges
to operations over the vesting period of the options, consistent with the
methods described in FASB Interpretation No. 28.

Stock-based compensation, a noncash expense, decreased 53% to $816,000 for
the three months ended September 30, 2001 from $1.7 million for the three months
ended September 30, 2000. Unearned stock based compensation is recognized over
the period during which the underlying stock options vest, generally four years.

Amortization of Goodwill and Purchased Intangibles. During the quarter
ended September 30, 2001, we recorded amortization of goodwill and purchased
intangibles of $375,000. The goodwill and purchased intangibles relate to the
July 31, 2000 acquisition of MineShare and are being amortized over three years.

Write-off of Acquired In-process Research and Development and Fixed
Assets. Nonrecurring charges recorded during the quarter ended September 30,
2000 ($4.6 million) consisted primarily of the write-off of purchased in-process
research and development and fixed assets associated with the acquisition of
MineShare.

Interest Income, Net. Interest income decreased to $141,000 for the
quarter ended September 30, 2001 from $868,000 for the quarter ended September
30, 2000. The decrease is largely due to lower average cash and cash equivalents
balances resulting from the use of cash to fund current operations and lower
prevailing interest rates.

SIX MONTHS ENDED SEPTEMBER 30, 2001 AND 2000

Revenues. Total revenues increased 3% to $18.4 million for the six months
ended September 30, 2001 from $17.8 million for the six months ended September
30, 2000. The increase was primarily due to increased volume and revenue from
continuing clients, partially offset by a decline in total clients from
September 2000 through September 2001 as well a temporary decline in email
volume related to the events of September 11th.

Cost of Revenues. Total cost of revenues increased to $8.8 million for six
months ended September 30, 2001 from $7.9 million for the six months ended
September 30, 2000. The increase was primarily due to higher costs of campaign
creation and delivery associated with supporting a higher volume of campaigns,
and the expansion of our data center infrastructure. Gross margins declined to
52% for the six months ended September 30, 2001 from 56% for the six months
ended September 30, 2000, largely due to continued investment in our data center
infrastructure, resulting in excess capacity that when spread over our revenue
base resulted in slightly lower margins.

Research and Development. Research and development expenses consist
primarily of personnel and related costs, consultants and outside contractor
costs, and software and hardware maintenance costs for our development efforts.
To date, all research and development costs have been expensed as incurred.
Research and development expenses declined by 15% to $6.7 million for the six
months ended September 30, 2001 from $7.9 million for the six months ended
September 30, 2000. The decline is primarily a result of a decrease in personnel
costs of approximately $800,000, largely related to the decrease in engineering
staff associated with our April and September realignment initiatives, and a
$1.3 million reduction in outside consulting expenses related to continuing
efforts to meet development needs with internal resources. This was offset by a
$322,000 increase in amortized tangible purchased technology expense related to
our MineShare acquisition and a $400,000 increase in allocated corporate
overhead. We expect to continue to make investments in research and development.

Sales and Marketing. Sales and marketing expenses consist of personnel and
related costs primarily for our direct sales force and marketing staff, as well
as marketing programs, which include trade shows, advertisements, promotional
activities and media events. Sales and marketing expenses increased 9% to $8.9
million for the six months ended September 30, 2001 from $8.2 million for the
six months ended September 30, 2000. The increase was primarily due to an
increase in personnel costs of $100,000 related to expansion of our sales
organization and an increase in marketing costs of $500,000 related to expanded
advertising and promotional activities.

General and Administrative. General and administrative expenses consist
primarily of personnel and related costs for general corporate purposes,
including information services, finance, accounting, human resources, facilities
and legal. General and administrative expenses declined by 9% to $4.6 million
for the six months ended September 30, 2001 from $5.1 million for the six months
ended September 30, 2000. The decrease was primarily the result of a decrease in
travel and entertainment expenses and a reduction in bad debt expense.

Stock-based compensation, a noncash expense, decreased 43% to $2.2 for the
six months ended September 30, 2001 from $3.8 million for the six months ended
September 30, 2000. Unearned stock based compensation is recognized over the
period during which the underlying stock options vest, generally four years.

Amortization of Goodwill and Purchased Intangibles. During the six months
ended September 30, 2001, we recorded amortization of goodwill and purchased
intangibles of $750,000. The goodwill and purchased intangibles relate to the
July 31, 2000 acquisition of MineShare and are being amortized over three years.

Write-off of Acquired In-process Research and Development. Nonrecurring
charges recorded during the six months ended September 30, 2000 ($4.6 million)
consisted primarily of the write-off of purchased in-process research and
development and fixed assets associated with the acquisition of MineShare.

Interest Income, Net. Interest income decreased to $325,000 for the six
months ended September 30, 2001 from $1.8 million for the six months ended
September 30, 2000. The decrease is largely due to lower average cash and cash
equivalents balances resulting from the use of cash to fund current operations
and lower prevailing interest rates.

LIQUIDITY AND CAPITAL RESOURCES

Net cash used in operating activities was $5.0 million for the six months
ended September 30, 2001, which was due primarily to a net loss of $13.2
million, a $2.2 decline in accounts payable and an increase in prepaid expenses
and other current assets of $263,000. This was partially offset by noncash
charges including the amortization of stock-based compensation ($2.2 million)
and depreciation and amortization ($3.8 million), as well as a decrease of $5.0
million in accounts receivable related to aggressive collection efforts and
tighter credit standards. Net cash used in operating activities for the six
months ended September 30, 2000 was $11.9 million.

Our investing activities used $1.3 million during the six months ended
September 30, 2001, which was attributable primarily to the acquisition of
property and equipment related to investments in our data center infrastructure.
Cash used in investing activities for the six months ended September 30, 2000
was $4.8. million.

Financing activities used $780,000 during the six months ended September
30, 2001, which was attributable primarily to payments on long-term debt. This
was partially offset by proceeds from the exercise of stock options and the
purchase of shares through our employee stock purchase plan. During the six
months ended September 30, 2000, cash provided by financing activities was
$621,000.

At September 30, 2001, we had $28.0 million in cash and cash equivalents
and availability of $160,000 under a leasing line of credit. Amounts borrowed
under this leasing line of credit totaled approximately $531,000 at September
30, 2001 and bear interest at rates of between 6.2% and 10.1%. We had $625,000
outstanding under an equipment leasing line, which is secured by the leased
assets and bears interest at a rate of 9.5%. We also had $2.6 million
outstanding under a term loan. The loan bears interest at the three-year
Treasury rate plus 950 basis points (12.72% as of September 30, 2001) and is
secured by the leased assets. Our MineShare subsidiary had approximately $41,000
outstanding under a $50,000 revolving line of credit that bears interest at
prime plus 3% (9.0% as of September 30, 2001). We have an equipment loan
facility with a maximum borrowing limit of $800,000, which is secured by the
equipment of our MineShare subsidiary and bears interest at a rate of 10%. As of
September 30, 2001, approximately $271,000 was outstanding under this facility.
We have a second equipment loan facility with a borrowing limit of $1,000,000,
which is secured by the equipment of our MineShare subsidiary, and bears
interest at a rate of 10%. As of September 30, 2001, approximately $66,000 was
outstanding under this facility.

Our other principal commitments at September 30, 2001 consisted of
obligations under operating leases for facilities and our pledge of $1.9 million
of cash as collateral for an outstanding letter of credit. For additional
information, see the financial statements. We believe that our existing cash and
cash equivalents will be sufficient to satisfy our currently anticipated cash
requirements for the next twelve months.

RECENT ACCOUNTING PRONOUNCEMENTS

In July 2001, the Financial Accounting Standards Board issued SFAS No. 141
"Business Combinations," which establishes financial accounting and reporting
for business combinations and supersedes APB Opinion No. 16, Business
Combinations, and FASB Statement No. 38, Accounting for Preacquisition
Contingencies of Purchased Enterprises. It requires that all business
combinations in the scope of this Statement are to be accounted for using one
method, the purchase method. The provisions of this Statement apply to all
business combinations initiated after June 30, 2001, and also applies to all
business combinations accounted for using the purchase method for which the date
of acquisition is July 1, 2001, or later.

In July 2001, the Financial Accounting Standards Board issued SFAS No. 142
"Goodwill and Other Intangible Assets," which establishes financial accounting
and reporting for acquired goodwill and other intangible assets and supersedes
APB Opinion No. 17, Intangible Assets. It addresses how intangible assets that
are acquired individually or with a group of other assets (but not those
acquired in a business combination) should be accounted for in financial
statements upon their acquisition, and after they have been initially recognized
in the financial statements. The provisions of this Statement are effective
starting with fiscal years beginning after December 15, 2001. Early adoption is
permitted for entities with fiscal years beginning after March 15, 2001,
provided that the first interim financial statements have not previously been
issued. Accordingly, the Company has elected not to early adopt SFAS No. 142
beginning with the first quarter of fiscal 2002. Upon adoption of FAS 142, the
Company will reclassify the amount relating to assembled workforce (currently
$1.6 million) from intangible assets to goodwill and will no longer amortize
goodwill.

CERTAIN FACTORS WHICH MAY IMPACT FUTURE OPERATING RESULTS

Our future operating results may vary substantially from period to period
due to a number of factors, many of which are beyond our control. The following
discussion highlights some of these factors and the possible impact of these
factors on future results of operations. If any of the following factors
actually occur, our business, financial condition or results of operations could
be harmed. In that case, the price of our common stock could decline, and
investors could experience losses on their investment.

BECAUSE OF OUR LIMITED OPERATING HISTORY AND THE EMERGING NATURE OF THE ONLINE
DIRECT MARKETING INDUSTRY, ANY PREDICTIONS ABOUT OUR FUTURE REVENUES AND
EXPENSES MAY NOT BE AS ACCURATE AS THEY WOULD BE IF WE HAD A LONGER BUSINESS
HISTORY, AND WE CANNOT DETERMINE TRENDS THAT MAY AFFECT OUR BUSINESS.

We were incorporated in October 1997 in California and reincorporated in
Delaware in October 1999. Our limited operating history makes financial
forecasting and evaluation of our business difficult. Since we have limited
financial data, any predictions about our future revenues and expenses may not
be as accurate as they would be if we had a longer business history. Because of
the emerging nature of the online direct marketing industry, we cannot determine
trends that may emerge in our market or affect our business. The revenue and
income potential of the online direct marketing industry, and our business, are
unproven.

OUR OPERATING RESULTS HAVE VARIED SIGNIFICANTLY IN THE PAST AND ARE LIKELY TO
VARY SIGNIFICANTLY FROM PERIOD TO PERIOD, AND OUR STOCK PRICE MAY DECLINE IF
WE FAIL TO MEET THE EXPECTATIONS OF ANALYSTS AND INVESTORS.

Our operating results have varied significantly in the past and are likely
to vary significantly from period to period. As a result, our operating results
are difficult to predict and may not meet the expectations of securities
analysts or investors. If this occurs, the price of our common stock would
likely decline.

SEASONAL TRENDS MAY CAUSE OUR QUARTERLY OPERATING RESULTS TO FLUCTUATE, WHICH
MAY ADVERSELY AFFECT THE MARKET PRICE OF OUR COMMON STOCK.

The traditional direct marketing industry has typically generated lower
revenues during the summer months and higher revenues during the calendar
year-end months. Because we do experience these effects, analysts and investors
may not be able to predict our quarterly or annual operating results. If we fail
to meet expectations of analysts and investors, our stock price could decline.

IF BUSINESSES AND CONSUMERS FAIL TO ACCEPT ONLINE DIRECT MARKETING AS A MEANS
TO ATTRACT NEW CUSTOMERS, DEMAND FOR OUR SERVICES MAY NOT DEVELOP AND THE
PRICE OF OUR STOCK COULD DECLINE.

The market for online direct marketing services is relatively new and
rapidly evolving, and our business may be harmed if sufficient demand for our
services does not develop. Our current and planned services are very different
from the traditional methods that many of our clients have historically used to
attract new customers and maintain customer relationships.

THE LOSS OF A MAJOR CLIENT COULD RESULT IN LOWER THAN EXPECTED REVENUES.

The loss of a major client could harm our business. While no single client
accounted for more than 10% of our revenues for the quarter ended September 30,
2001, the loss of a major client could have a material adverse effect on our
business and results of operations. Additionally, some Internet-based businesses
have recently been experiencing financial problems. While the majority of our
clients are not Internet-based businesses, the loss of a number of these clients
could have a material adverse effect on our business and our results of
operations.

THE ONLINE DIRECT MARKETING INDUSTRY IS HIGHLY COMPETITIVE, AND IF WE ARE
UNABLE TO COMPETE EFFECTIVELY, THE DEMAND FOR, OR THE PRICES OF, OUR SERVICES
MAY DECLINE.

The market for online direct marketing is highly competitive, rapidly
evolving and experiencing rapid technological change. Intense competition may
result in price reductions, reduced sales, gross margins and operating margins,
and loss of market share. Our principal competitors include providers of online
direct marketing solutions such as Exactis.com (recently acquired by Experian,
DoubleClick (through its acquisition of FloNetwork and its proposed acquisition
of MessageMedia), Responsys.com, Netcentives Inc. (through its subsidiary Post
Communications), and Annuncio Software, Inc., as well as the in-house
information technology departments of our existing and prospective clients.

In addition, we expect competition to persist and intensify in the future,
which could harm our ability to increase sales and maintain our prices. In the
future, we may experience competition from Internet service providers,
advertising and direct marketing agencies and other large established businesses
such as America Online, Microsoft, IBM, AT&T, Yahoo!, ADVO, CMGI, Inc., and the
Interpublic Group of Companies. Each of these companies possesses large,
existing customer bases, substantial financial resources and established
distribution channels and could develop, market or resell a number of online
direct marketing solutions. These potential competitors may also choose to
enter, or have already entered, the market for online direct marketing by
acquiring one of our existing competitors or by forming strategic alliances with
a competitor.

Many of these potential competitors have broad distribution channels and
they may bundle competing products or services. As a result of future
competition, the demand for our services could substantially decline. Any of
these occurrences could harm our ability to compete effectively.

IF WE DO NOT ATTRACT AND RETAIN ADDITIONAL HIGHLY-SKILLED PERSONNEL, WE MAY BE
UNABLE TO EXECUTE OUR BUSINESS STRATEGY.

Our business depends on the continued technological innovation of our core
services and our ability to provide comprehensive online direct marketing
expertise. Our main offices are located in the San Francisco Bay Area, where
competition for personnel with Internet-related technology and marketing skills
is intense. If we fail to identify, attract, retain and motivate these highly
skilled personnel, we may be unable to successfully introduce new services or
otherwise implement our business strategy. As a public company we face greater
difficulty attracting and retaining personnel than we did as a private company.

WE RELY ON THE SERVICES OF OUR FOUNDERS AND OTHER KEY PERSONNEL, WHOSE
KNOWLEDGE OF OUR BUSINESS AND TECHNICAL EXPERTISE WOULD BE EXTREMELY DIFFICULT
TO REPLACE.

Our future success depends to a significant degree on the skills,
experience and efforts of our senior management. In particular, we depend upon
the continued services of our co-founders William Park, our Chief Executive
Officer, and Gerardo Capiel, our Chief Technology Officer, whose vision for our
company, knowledge of our business and technical expertise would be extremely
difficult to replace. In addition, we have not obtained life insurance
benefiting Digital Impact covering any of our key employees. If any of our key
employees left or was seriously injured and unable to work and we were unable to
find a qualified replacement, the level of services we are able to provide could
decline or we could be otherwise unable to execute our business strategy.

IF THE DELIVERY OF OUR EMAILS IS LIMITED OR BLOCKED, THEN OUR CLIENTS MAY
DISCONTINUE THEIR USE OF OUR SERVICES.

Our business model relies on our ability to deliver emails over the
Internet through Internet service providers and to recipients in major
corporations. In particular, a significant percentage of our emails are sent to
recipients who use America Online. We do not have, and we are not required to
have, an agreement with America Online to deliver emails to their customers.
America Online uses a proprietary set of technologies to handle and deliver
email and the value of our services will be reduced if we are unable to provide
emails compatible with these technologies. In addition, America Online and other
Internet service providers are able to block unwanted messages to their users.
If these companies limit or halt the delivery of our emails, or if we fail to
deliver emails in such a way as to be compatible with these companies' email
handling technologies, then our clients may discontinue their use of our
services.

OUR FACILITIES AND SYSTEMS ARE VULNERABLE TO NATURAL DISASTERS AND OTHER
UNEXPECTED EVENTS, AND ANY OF THESE EVENTS COULD RESULT IN AN INTERRUPTION OF
OUR ABILITY TO EXECUTE OUR CLIENTS' ONLINE DIRECT MARKETING CAMPAIGNS.

We depend on the efficient and uninterrupted operations of our data center
and hardware systems. Our data center and hardware systems are located in
Northern California, an area susceptible to earthquakes. Our data center and
hardware systems are also vulnerable to damage from fire, floods, power loss,
telecommunications failures, and similar events. If any of these events results
in damage to our data center or systems, we may be unable to execute our
clients' online direct marketing campaigns until the damage is repaired, and may
accordingly lose clients and revenues. In addition, we may incur substantial
costs in repairing any damage.

OUR DATA CENTER IS LOCATED AT FACILITIES PROVIDED BY A THIRD PARTY, AND IF
THIS PARTY IS UNABLE TO ADEQUATELY PROTECT OUR DATA CENTER, OUR REPUTATION MAY
BE HARMED AND WE MAY LOSE CLIENTS.

Our data center, which is critical to our ongoing operations, is located at
facilities provided by a third party. Our operations depend on this party's
ability to protect our data center from damage or interruption from human error,
break-ins, sabotage, computer viruses, intentional acts of vandalism and similar
events. If this party is unable to adequately protect our data center and
information is lost or our ability to deliver our services is interrupted, our
reputation may be harmed and we may lose clients.

IF WE ARE UNABLE TO ADEQUATELY PROTECT OUR INTELLECTUAL PROPERTY, THIRD
PARTIES COULD USE OUR INTELLECTUAL PROPERTY WITHOUT OUR CONSENT.

Our ability to successfully compete is substantially dependent upon our
internally developed technology and intellectual property, which we protect
through a combination of copyright, trade secret and trademark law, and
contractual obligations. We have no issued patents and have two U.S. patent
applications pending. We have nine registered U.S. trademarks and have three
trademark applications pending in the U.S. and Europe. We may not be able to
adequately protect our proprietary rights. Unauthorized parties may attempt to
obtain and use our proprietary information. Policing unauthorized use of our
proprietary information is difficult, and we cannot be certain that the steps we
have taken will prevent misappropriation, particularly in foreign countries
where the laws may not protect our proprietary rights as fully as in the United
States.

IF WE ARE UNABLE TO SAFEGUARD THE CONFIDENTIAL INFORMATION IN OUR DATA
WAREHOUSE, OUR REPUTATION MAY BE HARMED AND WE MAY BE EXPOSED TO LIABILITY.

We currently store confidential customer information in a secure data
warehouse. We cannot be certain, however, that we will be able to prevent
unauthorized individuals from gaining access to this data warehouse. If any
compromise or breach of security were to occur, it could harm our reputation and
expose us to possible liability. Any unauthorized access to our servers could
result in the misappropriation of confidential customer information or cause
interruptions in our services. It is also possible that one of our employees
could attempt to misuse confidential customer information, exposing us to
liability. In addition, our reputation may be harmed if we lose customer
information maintained in our data warehouse due to systems interruptions or
other reasons.

ACTIVITIES OF OUR CLIENTS COULD DAMAGE OUR REPUTATION OR GIVE RISE TO LEGAL
CLAIMS AGAINST US.

Our clients' promotion of their products and services may not comply with
federal, state and local laws, including but not limited to laws and regulations
surrounding the Internet. We cannot predict whether our role in facilitating
these marketing activities would expose us to liability under these laws. Any
claims made against us could be costly and time-consuming to defend. If we are
exposed to this kind of liability, we could be required to pay substantial fines
or penalties, redesign our business methods, discontinue some of our services or
otherwise expend resources to avoid liability.

Our services involve the transmission of information through the Internet.
Our services could be used to transmit harmful applications, negative messages,
unauthorized reproduction of copyrighted material, inaccurate data or computer
viruses to end-users in the course of delivery. Any transmission of this kind
could damage our reputation or could give rise to legal claims against us. We
could spend a significant amount of time and money defending against these legal
claims.

NEW REGULATION OF, AND UNCERTAINTIES REGARDING THE APPLICATION OF EXISTING
LAWS AND REGULATIONS TO, ONLINE DIRECT MARKETING AND THE INTERNET COULD
PROHIBIT, LIMIT OR INCREASE THE COST OF OUR BUSINESS.

Legislation has been enacted in several states restricting the sending of
unsolicited commercial email. We cannot assure you that existing or future
legislation regarding commercial email will not harm our business. The federal
government, foreign governments and several other states are considering, or
have considered, similar legislation. These provisions generally limit or
prohibit both the transmission of unsolicited commercial emails and the use of
forged or fraudulent routing and header information. Some states, including
California, require that unsolicited emails include opt-out instructions and
that senders of these emails honor any opt-out requests.

Our business could be negatively impacted by new laws or regulations
applicable to online direct marketing or the Internet, the application of
existing laws and regulations to online direct marketing or the Internet or the
application of new laws and regulations to our business as we expand into new
jurisdictions. There is a growing body of laws and regulations applicable to
access to or commerce on the Internet. Moreover, the applicability to the
Internet of existing laws is uncertain and may take years to resolve. Due to the
increasing popularity and use of the Internet, it is likely that additional laws
and regulations will be
18

adopted covering issues such as privacy, pricing, content, copyrights,
distribution, taxation, antitrust, characteristics and quality of services and
consumer protection. The adoption of any additional laws or regulations may
impair the growth of the Internet or online direct marketing, which could, in
turn, decrease the demand for our services and prohibit, limit or increase the
cost of our doing business.

INTERNET-RELATED STOCK PRICES ARE ESPECIALLY VOLATILE AND THIS VOLATILITY MAY
DEPRESS OUR STOCK PRICE.

The stock market and specifically the stock prices of Internet-related
companies have been very volatile. Because we are an Internet-related company,
we expect our stock price to be similarly volatile. As a result of this
volatility, the market price of our common stock could significantly decrease.
This volatility is often not related to the operating performance of the
companies and may accordingly reduce the price of our common stock without
regard to our operating performance.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

For the period from our inception through September 30, 2001, we provided
our services to clients primarily in the United States. As a result, our
financial results have not been directly affected by factors such as changes in
foreign currency exchange rates or weak economic conditions in foreign markets.
The majority of our sales are currently denominated in U.S. dollars. During the
quarter ended June 30, 2000, we established a subsidiary in the United Kingdom
which has had minimal operations to date. As the operations of this subsidiary
expand, our future operating results could be directly impacted by changes in
foreign currency exchange rates or economic conditions in this region. Our
exposure to market risk for changes in interest rates relates primarily to the
increase or decrease in the amount of interest income we can earn on our
investment portfolio and on the increase or decrease in the amount of interest
expense we must pay on our outstanding debt instruments. The risk associated
with fluctuating interest expense is limited, however, to the exposure related
to those debt instruments and credit facilities which are tied to market rates.
We do not plan to use derivative financial instruments in our investment
portfolio. We plan to ensure the safety and preservation of our invested
principal funds by limiting default risk, market risk and reinvestment risk. We
plan to mitigate default risk by investing in high-credit quality securities.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

ITEM 2. CHANGE IN SECURITIES AND USE OF PROCEEDS

In November 1999, we completed our initial public offering of 5,175,000
shares of our common stock, which included 675,000 shares in connection with the
exercise of the underwriters' overallotment option, at $15 per share. The
managing underwriters in the offering were Credit Suisse First Boston; Hambrecht
& Quist; Donaldson, Lufkin & Jenrette; and U.S. Bancorp Piper Jaffray. The sale
of our shares of common stock in the offering was registered under the
Securities Act of 1933, as amended, on a Registration Statement on Form S-1
(Reg. No. 333-87299) that was declared effective by the Securities and Exchange
Commission on November 22, 1999. The aggregate offering amount including the
overallotment exercise was approximately $77.6 million. We incurred expenses of
approximately $6.8 million, of which approximately $5.4 million represented
underwriting discounts and commissions and approximately $1.4 million
represented other expenses related to the offering.

Currently, we have placed the remaining net proceeds (approximately $28
million) from the offering in short-term, interest bearing, investment grade
securities. During the six months ended September 30, 2001, we used
approximately $7.0 million of the net proceeds to fund our general operations.
We expect to use the remaining offering net proceeds for working capital and
general corporate purposes, including continued investment in the development of
our current and future online direct marketing services, the expansion of our
sales and marketing activities, and investment in our infrastructure.
Additionally, we may use a portion of the net proceeds to acquire or invest in
complementary products, technologies, or businesses.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

At the Company's Annual Meeting of Stockholders ("Annual Meeting") held on
July 31, 2001, the following individual was re-elected to the Board of Directors
as a Class II director for the term of three years:

VOTES FOR VOTES WITHHELD
---------- --------------

Ruthann Quindlen........................................... 23,184,508 34,093

William Park, Gerardo Capiel, Warren Packard and Michael Brown continue as
either Class I, Class II or Class III directors of the Company.

Additionally, at the Company's Annual Meeting, the following proposal was
adopted by the margin indicated:

1. To ratify the appointment of PricewaterhouseCoopers LLP as our
independent accountants for the fiscal year ending March 31, 2002. The votes
cast for and against this action were 23,196,262 and 14,291, respectively, with
8,048 abstaining.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

Exhibits

None

Reports on Form 8-K

None

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.

DIGITAL IMPACT, INC.
(Registrant)

/s/ WILLIAM PARK
--------------------------------------
William Park
President, Chief Executive Officer and
Chairman of the Board of Directors
(Principal Executive Officer)

/s/ DAVID OPPENHEIMER
--------------------------------------
David Oppenheimer
Sr. Vice President, Chief Financial
Officer and Treasurer
(Principal Financial and Accounting
Officer)

Dated: November 13, 2001