e10vq
Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-Q

(Mark One)

     
[X]
  Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended June 30, 2004

OR

     
[  ]
  Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from                                        to                                       

Commission File Number: 000-27787

DIGITAL IMPACT, INC.

(Exact name of registrant as specified in its charter)
     
Delaware   94-3286913
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification No.)
     
177 Bovet Road, San Mateo, California   94402
(Address of principal executive offices)   (Zip Code)

Registrant’s telephone number, including area code: (650) 356-3400

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

Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.001 par value

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 [  ]

Indicate by check mark whether the registrant is an accelerated filer as defined in Rule 12b-2 of the Securities Exchange Act of 1934:

     
Yes [  ]   No [X]

As of August 11, 2004, there were approximately 35 million shares of the Registrant’s Common Stock outstanding.



 


DIGITAL IMPACT, INC.

INDEX

         
    Page No.
       
       
    3  
    4  
    5    
    6  
    7  
    14  
    28  
    29  
       
    29  
    29  
    29  
    30  
    30  
    30  
    32  
 EXHIBIT 31.1
 EXHIBIT 31.2
 EXHIBIT 32.1
 EXHIBIT 32.2

2


Table of Contents

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
    June 30,
    2004
  2003
Revenues
  $ 10,411     $ 10,928  
Cost of revenues
    5,135       4,788  
 
   
 
     
 
 
Gross profit
    5,276       6,140  
Operating expenses:
               
Research and development
    984       1,454  
Sales and marketing
    3,384       3,051  
General and administrative
    1,820       1,713  
Amortization of purchased intangibles
          161  
 
   
 
     
 
 
Total operating expenses
    6,188       6,379  
 
   
 
     
 
 
Loss from operations
    (912 )     (239 )
Other income (expense)
    28       (54 )
 
   
 
     
 
 
Net loss
  $ (884 )   $ (293 )
 
   
 
     
 
 
Basic and diluted net loss per share
  $ (0.03 )   $ (0.01 )
 
   
 
     
 
 
Weighted average shares used in basic and diluted net loss per share
    34,260       31,670  
 
   
 
     
 
 

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

3


Table of Contents

DIGITAL IMPACT, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
(Unaudited)
                 
    June 30,   March 31,
    2004
  2004
ASSETS
               
Current assets:
               
Cash and cash equivalents
  $ 25,727     $ 25,550  
Short-term investments
    108       608  
Accounts receivable, net
    7,765       8,172  
Prepaid expenses and other current assets
    1,491       1,385  
 
   
 
     
 
 
Total current assets
    35,091       35,715  
 
   
 
     
 
 
Property and equipment, net
    5,779       6,100  
Restricted cash
    1,164       1,164  
Goodwill
    2,002       2,002  
Other assets
    369       380  
 
   
 
     
 
 
Total assets
  $ 44,405     $ 45,361  
 
   
 
     
 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current liabilities:
               
Accounts payable
  $ 1,055     $ 1,100  
Accrued payroll
    1,386       1,647  
Accrued pass-through vendor costs
    736       659  
Accrued liabilities
    445       614  
Deferred revenues
    1,565       2,087  
Current portion of long-term debt
    333       158  
 
   
 
     
 
 
Total current liabilities
    5,520       6,265  
 
   
 
     
 
 
Long-term debt, less current portion
    174       80  
 
   
 
     
 
 
Total liabilities
    5,694       6,345  
 
   
 
     
 
 
Stockholders’ equity:
               
Preferred stock
           
Common stock
    35       34  
Additional paid-in capital
    146,115       145,540  
Accumulated other comprehensive income
    48       51  
Unearned stock-based compensation
          (6 )
Accumulated deficit
    (106,843 )     (105,959 )
Less treasury stock, at cost
    (644 )     (644 )
 
   
 
     
 
 
Total stockholders’ equity
    38,711       39,016  
 
   
 
     
 
 
Total liabilities and stockholders’ equity
  $ 44,405     $ 45,361  
 
   
 
     
 
 

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

4


Table of Contents

DIGITAL IMPACT, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(In thousands, except per share data)
(Unaudited)
                 
    Three Months Ended
    June 30,
    2004
  2003
Net loss
  $ (884 )   $ (293 )
 
   
 
     
 
 
Other comprehensive loss:
               
Cumulative translation adjustment
    (3 )     (60 )
 
   
 
     
 
 
Net changes in comprehensive loss
    (3 )     (60 )
 
   
 
     
 
 
Comprehensive loss
  $ (887 )   $ (353 )
 
   
 
     
 
 

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

5


Table of Contents

DIGITAL IMPACT, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
                 
    Three Months Ended
    June 30,
    2004
  2003
Cash flows from operating activities
               
Net loss
  $ (884 )   $ (293 )
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
               
Depreciation and amortization
    1,106       1,590  
Recovery of bad debts
          (70 )
Amortization of unearned stock-based compensation
          25  
Stock-based compensation
    28        
Loss (Gain) on disposal of fixed assets and other non-cash items
    (3 )     (71 )
Changes in operating assets and liabilities:
               
Accounts receivable
    407       1,687  
Prepaid expenses and other current assets
    (18 )     (218 )
Other assets
    11       26  
Accounts payable
    (45 )     407  
Accrued liabilities and accrued payroll
    (355 )     (368 )
Deferred revenue
    (522 )     (213 )
 
   
 
     
 
 
Net cash provided by (used in) operating activities
    (275 )     2,502  
 
   
 
     
 
 
Cash flows from investing activities Purchases of investments in marketable securities
          (998 )
Maturities of investments in marketable securities
    500        
Proceeds from sale of equipment
    3        
Acquisition of property and equipment
    (522 )     (745 )
 
   
 
     
 
 
Net cash used in investing activities
    (19 )     (1,743 )
 
   
 
     
 
 
Cash flows from financing activities
               
Principal payments on long-term debt and capital lease obligations
    (81 )     (464 )
Proceeds from issuance of common stock
    554       813  
Purchases of treasury stock
          (15 )
 
   
 
     
 
 
Net cash provided by financing activities
    473       334  
 
   
 
     
 
 
Effect of exchange rates on cash and cash equivalents
    (2 )     9  
Net increase in cash and cash equivalents
    177       1,102  
Cash and cash equivalents at beginning of period
    25,550       23,659  
 
   
 
     
 
 
Cash and cash equivalents at end of period
  $ 25,727     $ 24,761  
 
   
 
     
 
 
Supplemental non-cash information:
               
Assets acquired under capital leases and notes payable
  $ 350     $  
Unearned stock-based compensation cancellations
  $ (6 )   $ (41 )

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

6


Table of Contents

DIGITAL IMPACT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1. The Company

     Digital Impact, Inc. (the “Company” or “Digital Impact”) was incorporated in California in October 1997 and reincorporated in Delaware in October 1999. Digital Impact is a leading provider of integrated digital marketing solutions for Global 2000 enterprises. We draw on our industry specific expertise, our comprehensive methodology for creating programs to address specific marketing objectives and our proprietary technology platform to deliver marketing campaigns through email as well as website, search and other media.

     Digital Impact derives its revenues from the sale of solutions that enable businesses to proactively communicate with its customers online. Primarily, these services have consisted of the design and execution of online direct marketing campaigns, the development and execution of Customer Acquisition programs and additional services provided by the Agency Services organization.

     Digital Impact is organized into two segments: Email Marketing (previously known as Customer Marketing) and Agency Services (previously known as Professional Services). There have been no changes to the components of these segments. Email Marketing consists of creating and executing online direct marketing programs. Agency Services include several categories of services designed to improve campaign results.

     On July 12, 2004, the Company acquired all of the outstanding equity of MarketLeap.com, Inc. (see Note 8).

Note 2. Summary of Significant Accounting Policies

Basis of presentation and liquidity

     The condensed consolidated financial statements include the accounts of Digital Impact and its wholly owned subsidiary. All significant intercompany accounts and balances have been eliminated.

     The accompanying interim consolidated financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission. The accompanying interim consolidated financial statements are unaudited, but in the opinion of management, contain all the normal, recurring adjustments considered necessary to present fairly the financial position, the results of operations and cash flows for the periods presented in conformity with generally accepted accounting principles applicable to interim periods. Results of operations are not necessarily indicative of the results expected for the full fiscal year or for any 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, 2004.

     Certain reclassifications have been made to the prior years’ consolidated financial statements to conform to the current year’s presentation. The reclassifications had no effect on prior years’ stockholders’ equity and net loss.

     The Company incurred a net loss of approximately $884,000 for the three months ended June 30, 2004 and used $274,000 of cash in operating activities, compared to a net loss of $293,000 for the three months ended June 30, 2003 and $2.6 million provided by operating activities for that period.

     The Company continues to face risks associated with the execution of its strategy. Future cash flows and capital requirements depend on numerous factors, including market acceptance of its services, competition from new and existing competitors, the amount of resources it invests in its data center infrastructure and new product development, marketing and selling its products and services, brand promotions and any future acquisitions or divestitures.

     The Company’s primary source of liquidity is $25.7 million in cash and cash equivalents, and $108,000 in short-term investments. The Company believes it has the necessary financial resources to fund its working capital needs, capital expenditures and other business requirements for at least the next 12 months.

Use of estimates

     Preparation of the accompanying financial statements in conformity with generally accepted accounting principles requires management to make certain estimates and assumptions that affect the reported amounts of assets and

7


Table of Contents

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 reported period. Significant estimates include those required in the valuation of intangible assets acquired in business combinations, allowances for doubtful accounts and sales allowances. Actual results could differ from those estimates.

Foreign currency translation

     The functional currency for the Company’s U.K. subsidiary is the U.K. Pound. Assets and liabilities are translated using the exchange rate at the balance sheet date. Revenues, expenses, gains, and losses are translated using the average exchange rate for the month in which the transaction occurred. Translation gains and losses are recorded in accumulated other comprehensive income as a separate component of stockholders’ equity. Net gains and losses from foreign currency transactions are included in the Consolidated Statement of Operations and were not significant during any of the periods presented.

Revenue Recognition

     The Company generates revenue from the sale of solutions that enable businesses to proactively communicate with its customers online.

     Digital Impact applies the provisions of Staff Accounting Bulletin 104 “Revenue Recognition” and recognizes revenue when persuasive evidence of an arrangement exists, the service has been delivered, the fee is fixed or determinable and collection of the resulting receivables is reasonably assured. Email Marketing revenues are recognized upon sending the campaigns. Revenues attributable to one-time set-up fees for service initiation are deferred and recognized ratably over the term of the client’s service agreement, typically twelve months. Customer Acquisition revenues are derived primarily from programs that assist clients in growing their email lists through the use of third-party list rentals. Customer Acquisition programs fall into three general categories: List Rental, ProspectNet and search engine marketing programs. List Rental programs involve the execution and delivery of email campaigns to a defined number of individuals provided by a third-party list rental or email address marketing service. ProspectNet programs involve the strategic placement of a Digital Impact client offer on a third-party site for the purpose of generating new opt-in email addresses for the client. Search engine marketing involves the expert management of search, placement, traffic flow, and analytical data for our clients. Digital Impact contracts with third-party providers to deliver names of individuals who opt-in to join the client’s email list or, in the use of search, to deliver specific content in response to user search queries. Digital Impact is obligated to make payments to third parties for the cost of services associated with the execution of List Rental, ProspectNet and search engine marketing programs. Digital Impact accounts for revenues and costs associated with Customer Acquisition programs in accordance with Emerging Issues Task Force Issue No. 99-19 (EITF 99-19), “Reporting Revenue Gross as a Principal versus Net as an Agent.” The cost of Customer Acquisition campaigns are recognized in the period that the programs are executed and are netted against program revenue. The cost of Customer Acquisition campaigns are estimated using Company records of outstanding purchase commitments when final vendor invoices have not been received.

     Digital Impact recognizes revenue net of third-party costs because the majority of client and supplier contracts have the following characteristics: the supplier, not the Company, is the primary obligor in the arrangement, the Company has limited latitude in establishing the price charged to the client, the Company’s credit risk is sometimes mitigated by receiving prepayment or reduced credit terms from its clients before ordering from the supplier, the Company does not maintain any inventory related to Customer Acquisition programs, the Company does not make changes to any data acquired from the supplier, and the client approves the supplier selection and the service specifications.

     Digital Impact provides other complementary services to clients, such as strategy, solutions engineering, web-page development, creative design and data analytics. These services are typically billed on an hourly or project basis. The revenue for engagements that support the delivery of future products and services, such as targeted solutions, is deferred at the time of delivery and recognized pro-rata over the future periods of usage. The period over which the revenue is recognized varies, generally between one and twelve months, depending on the term of the contract or the estimated period of usage. Management uses their best estimates to determine the appropriate period for revenue deferral.

     The Company assesses the probability of collection based on a number of factors, including its past transaction history with the customer and the credit-worthiness of the customer. New customers and certain existing customers are subject to a credit review process that evaluates the customers’ financial position and ultimately their ability to pay according to the original terms of the arrangement. Based on the Company’s review process, if it is determined from the outset or during the term of an arrangement that collection of the resulting receivable is not probable, then revenue is recognized on a cash-collected basis.

Cash, cash equivalents and short-term investments

8


Table of Contents

     The Company considers all highly liquid investments with an original or remaining maturity of three months or less at the time of purchase to be cash equivalents.

     Short-term investments consist of certificates of deposit and are classified as current assets because they have a maturity of less than one year.

     Digital Impact classifies short-term investments as available-for-sale. Accordingly, these investments are carried at fair value, with unrealized gains and losses reported as a separate component of stockholders’ equity. Digital Impact realizes gains or losses when these investments are sold using the specific identification method. Digital Impact has not recognized any material gains or losses from the sale of short-term investments.

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, short-term investments 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. For the three months ended June 30, 2004, two customers represented 12% and 11% of revenue, respectively. For the three months ended June 30, 2003, two customers represented 13% and 10% of revenue, respectively. As of June 30, 2004, one customer represented 10% of accounts receivable. As of June 30, 2003, two customers represented 15% and 12% of accounts receivable, respectively.

Research and development expense

     Research and development expenses consist primarily of salary and related personnel expense, consulting fees and other operating expenses related to the research and development departments. The research and development departments perform new product development, enhance and maintain existing products and perform quality assurance. With the exception of capitalized software development costs, research and development costs are expensed as incurred.

     The Company follows the provisions outlined in Statement of Position 98-1 “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use” related to the treatment of costs.

     The Company capitalizes certain direct costs incurred in the development of internal use software. For the three months ended June 30, 2004, the Company capitalized approximately $17,000 in software development costs. These costs are being amortized using the straight-line method over the estimated useful life of the software, generally two years, beginning when the software is ready for use. These amounts are included in property and equipment in the accompanying consolidated balance sheet.

Long-lived assets

     Property and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation and amortization is computed using the straight-line method over the shorter of the estimated useful lives of the assets, generally three to five years, or the lease term, if applicable. Gains and losses upon asset disposal are taken into Other Income (Expense) in the year of disposition. Maintenance and repairs are charged to operations as incurred.

     Long-lived assets, such as property and equipment and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated discounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated fair value, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of are separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated.

Goodwill and other intangible assets

     In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets” (“SFAS No. 142”), goodwill is no longer subject to amortization, but rather is subject to at least an

9


Table of Contents

annual assessment for impairment. The Company completed its annual impairment test in March 2004 and determined that no impairment existed.

Income taxes

     Deferred tax assets and liabilities are determined based on the differences between financial reporting and tax basis of assets and liabilities, measured at tax rates that will be in effect when the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized. As of June 30, 2004, the Company had recorded a full valuation allowance against its deferred tax assets.

Recent accounting pronouncements

     On March 31, 2004, the FASB issued a proposed Statement, “Share-Based Payment, an amendment of FASB Statements Nos. 123 and 95,” that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for either equity instruments of the enterprise or, liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. The proposed statement would eliminate the ability to account for share-based compensation transactions using Accounting Principles Board, or APB, Opinion No. 25, “Accounting for Stock Issued to Employees,” and generally would require that such transactions be accounted for using a fair-value-based method and recognized as expenses in our consolidated statement of income. The proposed standard would require the modified prospective method be used, which would require that the fair value of new awards granted from the beginning of the year of adoption plus unvested awards at the date of adoption be expensed over the vesting period. In addition, the proposed statement encourages companies to use the “binomial” approach to value stock options, which differs from the Black-Scholes option pricing model that we currently use to determine the fair value of our options. The proposed standard is recommending that the effective date for public companies be fiscal years beginning after December 15, 2004. Should this proposed statement be finalized in its current form, it will have a significant impact on our consolidated statement of operations as we will be required to expense the fair value of our stock options rather than disclosing the impact on our consolidated net loss within our notes as is our current practice.

Note 3. Stock-Based Compensation

     SFAS No. 123, “Accounting for Stock-Based Compensation” (“FSAS No. 123”), as amended by SFAS No. 148, permits companies to measure the compensation cost of stock-based awards based on either their intrinsic value or their estimated fair value at the date of grant and recognize the amount over the related service period. Therefore, as permitted by SFAS No. 123 and SFAS No. 148, the Company accounts for its employee stock option plans under the intrinsic value method, in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. As such, compensation expense related to the granting of employee stock options is recorded over the vesting period only if, on the date of grant, the fair value of the underlying stock exceeds the option’s exercise price. Digital Impact has adopted the disclosure-only requirements of SFAS No. 123, which allows entities to continue to apply the provisions of APB No. 25 for transactions with employees and provide pro forma net income and pro forma earnings per share disclosures for employee stock grants made as if the fair value based method of accounting in SFAS No. 123 had been applied to these transactions.

     Had the Company determined compensation expense of employee stock options based on the estimated fair value of the stock options at the grant date, consistent with the guidelines of SFAS 123, the net loss would have been increased to the pro forma amounts indicated below (in thousands, except per share amounts):

                 
    Three Months Ended
    June 30,
    2004
  2003
Net loss, as reported
  $ (884 )   $ (293 )
Add: Stock-based employee compensation expense included in reported net loss
          25  
Deduct: total stock-based compensation determined under fair value based method for all awards
    (644 )     (374 )
 
   
 
     
 
 
Pro forma net loss, fair value method for all stock-based awards
  $ (1,528 )   $ (642 )
 
   
 
     
 
 
Basic and diluted net loss per share:
               

10


Table of Contents

                 
    Three Months Ended
    June 30,
    2004
  2003
As reported
  $ (0.03 )   $ (0.01 )
Pro forma
  $ (0.04 )   $ (0.02 )

     The fair value for each option granted was estimated at the date of grant using the Black-Scholes option-pricing model, assuming no expected dividends and the following weighted average assumptions:

                                 
    Stock Options
  Employee Stock Purchase Plan
    Three Months Ended June 30,
  Three Months Ended June 30,
    2004
  2003
  2004
  2003
Expected volatility
    70 %     90 %     70 %     90 %
Weighted average risk-free interest rate
    3.72 %     2.63 %     1.78 %     1.18 %
Expected life in years
    4.0       6.5       .75       .75  
Expected dividends
    0 %     0 %     0 %     0 %

     Based on the above assumptions, the weighted average fair value per share of options granted at fair market value for the three months ended June 30, 2004 and 2003 was $1.74 and $1.48, respectively. No options were granted below fair market value during these periods.

     The pro forma impact of options on the net loss for the three months ended June 30, 2004 and 2003 may not be representative of the effects on net income (loss) for future years, as future years will include the effects of additional years of stock option grants.

11


Table of Contents

Note 4. Net Loss per Common Share

     Basic net loss per share is calculated by dividing net loss by the weighted average number of vested common shares outstanding for the period. Diluted net loss per share is calculated giving effect to all dilutive potential common shares, including options and preferred stock. A reconciliation of the numerators and denominators used in the basic and diluted net loss per share amounts follows (amounts in thousands, except per share data):

                 
    Three Months Ended June 30,
    2004
  2003
Numerator:
               
Net loss
  $ (884 )   $ (293 )
 
   
 
     
 
 
Denominator:
               
Weighted average common shares outstanding
    34,260       31,670  
Net loss per common share – basic and diluted
  $ (0.03 )   $ (0.01 )

     The following 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 (in thousands):

                 
    Three Months Ended June 30,
    2004
  2003
Options
    7,252       7,062  
Shares subject to repurchase
          81  

Note 5. Restructuring Charges

     In the fourth fiscal quarter of 2004, the Company initiated a cost reduction resulting in the closure of our Santa Monica office in December 2004 and the termination of 19 employees. As of June 30, 2004, approximately $30,000 remained in “Accrued Liabilities” for future severance payments. It is expected to be paid by the end of December 2004.

Note 6. Contingencies

     In June 2001, a series of putative securities class actions were filed in United States District Court for the Southern District of New York against certain investment bank underwriters for the Company’s initial public offering (“IPO”), the Company, and various of the Company’s officers and directors. The complaints, which have been consolidated under the caption In re Digital Impact, Inc. Initial Public Offering Securities Litigation, Civil Action No. 01-CV-4942, allege undisclosed and improper practices concerning the allocation of the Company’s IPO shares, in violation of the federal securities laws, and seek unspecified damages on behalf of persons who purchased the Company’s stock during the period from November 22, 1999 to December 6, 2000. The Court has appointed a lead plaintiff for the consolidated cases. On April 19, 2002, plaintiffs filed an amended complaint. Other actions have been filed making

12


Table of Contents

similar allegations regarding the IPOs of more than 300 other companies. All of these lawsuits have been coordinated for pretrial purposes as In re Initial Public Offering Securities Litigation, Civil Action No. 21-MC-92. Defendants in these cases filed omnibus motions to dismiss on common pleading issues. Oral argument on these omnibus motions to dismiss was held on November 1, 2002. The Company’s officers and directors have been dismissed without prejudice in this litigation. On February 19, 2003, the court granted in part and denied in part the omnibus motion to dismiss. The court’s order did not dismiss any claims against the Company.

     A stipulation of settlement for the claims against the issuer-defendants, including the Company, has been submitted to the court. The settlement is subject to a number of conditions, including approval of the court. If the settlement does not occur, and litigation against the Company continues, the Company believes it has meritorious defenses and intends to defend the case vigorously. The outcome of this litigation is uncertain and no estimate of liability can be made at this time.

     On February 23, 2004, the Company filed a patent infringement lawsuit against Responsys, Inc., a competitor of the Company. The lawsuit, captioned Digital Impact, Inc. v. Responsys, Inc., N. D. Cal., Case No. C04 00734 (SBA), alleges that Responsys has infringed and is continuing to infringe the Company’s U.S. Patent No. 6,449,634. The complaint seeks injunctive relief and unspecified damages. Responsys filed an answer and counterclaim on March 15, 2004. The counterclaim seeks a declaration that the patent is invalid or, in the alternative, that Responsys’s technology does not infringe the patent. The Company replied to the counterclaim on April 7, 2004, denying all material allegations. Responsys then filed a motion for judgment on the pleadings, which was denied on June 4, 2004.

Note 7. Segment Reporting

     Digital Impact is organized into two segments: Email Marketing and Agency Services, previously known as Customer Marketing and Professional Services, respectively. These segments were determined in fiscal 2003 based on the alignment of the Company’s organization structure and selected management financial reporting with the nature of the service product offerings.

     Email Marketing provides clients with comprehensive solutions for creating and executing online direct marketing programs. Our solutions are designed to enable marketers to drive revenue and deepen customer relationships with a comprehensive process that includes: collecting and managing customer information, analyzing the information to determine ideal segments and offers, and delivering highly relevant, individualized email messages. Email Marketing represented 73% and 69% of revenue for the three months ended June 30, 2004 and 2003, respectively. The gross margin for Email Marketing was 52% and 59% for the three months ended June 30, 2004 and 2003, respectively.

     Agency Services are utilized by clients to enhance marketing programs and improve results. Digital Impact offers clients services in each of the following categories: Strategic Marketing, Search and Acquisition Services, Creative Services, Web Development, Data Management, Measurement and Analytics, Campaign Automation, and Program Delivery. Agency Services represented 27% and 31% of revenue for the three months ended June 30, 2004 and 2003, respectively. The gross margin for Agency Services was 46% and 51% for the three months ended June 30, 2004 and 2003, respectively.

     Business segment revenues, gross profit and net loss are as follows (in thousands):

                 
    Three Months Ended
    June 30,
    2004   2003
Email Marketing revenue
  $ 7,578     $ 7,534  
Agency Services revenue
    2,833       3,394  
 
   
 
     
 
 
Total revenues
    10,411       10,928  
Email Marketing gross profit
    3,977       4,420  
Agency Services gross profit
    1,299       1,720  
 
   
 
     
 
 
Total gross profit
    5,276       6,140  
Operating expenses (not allocated between the segments)
    (6,188 )     (6,379 )
Other income (expense)
    28       (54 )
 
   
 
     
 
 
Net loss
  $ (884 )   $ (293 )
 
   
 
     
 
 

Note 8. Subsequent Event

     On July 12, 2004, the Company acquired MarketLeap.com, Inc. (“Marketleap”), a San Francisco based internet marketing firm specializing in search engine marketing services. The Company believes that this acquisition will

13


Table of Contents

enable Digital Impact to enhance its robust integrated marketing solutions by offering clients industry-leading search engine optimization, paid inclusion and pay-for-placement solutions. Under the terms of this agreement, Digital Impact acquired all of the outstanding equity of Marketleap for $1.5 million in cash and 1.25 million Digital Impact shares and options. Additional contingent consideration of up to 200,000 shares of Digital Impact common stock will become issuable at the end of Digital Impact’s 2005 fiscal year if certain revenue milestones are met.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

     The following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Additional factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section entitled “Risk Factors”, included elsewhere in this Annual Report. When used in this document, the words “believes,” “expects,” “anticipates,” “intends,” “plans” and similar expressions, are intended to identify certain of these forward-looking statements. However, these words are not the exclusive means of identifying such statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. The cautionary statements made in this document should be read as being applicable to all related forward-looking statements wherever they appear in this document. You should read the following discussion in conjunction with our Condensed Consolidated Financial Statements and related notes.

Overview

     Digital Impact is a leading provider of integrated digital marketing solutions for Global 2000 enterprises. We draw on our industry specific expertise, our comprehensive methodology for creating programs to address specific marketing objectives and our proprietary technology platform to deliver marketing campaigns through email as well as website, search and other media. We derive revenues and cash flows primarily from two business segments: Email Marketing and Agency Services.

     The Email Marketing segment derives revenue from 1) the IMPACT ™ (“IMPACT”) email software platform sold as a subscription-based hosted service; 2) account management services such as email campaign targeting, testing, delivery and reporting; and 3) program management teams which provide expertise in the design, management, analysis and optimization of marketing campaigns.

     The Agency Services segment derives revenue from project-based and retainer-based fees for marketing strategy, advanced analytics, data management, creative webpage design, customer acquisition and search engine marketing services.

     On July 12, 2004, the Company acquired all of the outstanding equity of MarketLeap.com, Inc. (see Note 8 of notes to unaudited Condensed Consolidated Financial Statements). We expect that the combination of Digital Impact’s strengths in email marketing with Marketleap’s experience in search engine marketing will offer clients true closed loop online marketing. Digital Impact expects to be able to assist clients in managing their customers through the entire lifecycle of awareness-consideration-purchase-loyalty, through a combination of email and search marketing strategy, analytics and campaign execution. Digital Impact expects the acquisition to result in approximately $1.5 million of additional net revenues for fiscal 2005.

     Costs of revenues are comprised of personnel expenses, data center equipment, software and hosting expenses and overhead.

     Members of our senior management regularly review key financial information including net revenues by segment, operating expenses and margins, net income, earnings per share, and cash flow. They also review key operating metrics such as email delivery volume, service mix and major account trends. This information allows us to monitor the growth and profitability of our business and evaluate the effectiveness of investments that we have made and continue to make in the areas of client services, product development, marketing and data center operations.

Critical Accounting Policies and Estimates

     Digital Impact’s consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. On an on-going basis, management evaluates its estimates, including those related to the revenue recognition, accounting for internal-use software, allowance for doubtful accounts, valuation of long-lived assets and goodwill, and accounting for stock-based

14


Table of Contents

compensation. Management bases its estimates on historical experience and various factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

     Management believes that the following critical accounting policies, among others, affect its more significant judgments and estimates used in the preparation of its consolidated financial statements:

  revenue recognition;
 
  estimating valuation allowances, specifically the allowance for doubtful accounts;
 
  accounting for internal-use software;
 
  valuation of long-lived assets and goodwill; and
 
  accounting for stock-based compensation.

     Revenue recognition. We generate revenue from the sale of solutions that enable businesses to proactively communicate with their customers online.

     Digital Impact applies the provisions of Staff Accounting Bulletin 104 “Revenue Recognition” and recognizes revenue when persuasive evidence of an arrangement exists, the service has been delivered, the fee is fixed or determinable and collection of the resulting receivables is reasonably assured. Email Marketing revenues are recognized upon sending of the campaigns. Revenues attributable to one-time set-up fees for service initiation are deferred and recognized ratably over the term of the client’s service agreement, typically twelve months. Customer Acquisition revenues are derived primarily from programs that assist clients in growing their email lists through the use of third-party providers. Customer Acquisition programs fall into three general categories: List Rental programs, ProspectNet programs, and search engine marketing. List Rental programs involve the execution and delivery of email campaigns to a defined number of individuals provided by a third-party list rental or email address matching service. ProspectNet programs involve the strategic placement of a Digital Impact client offer on a third-party site for the purpose of generating new opt-in email addresses for the client. Search engine marketing involves assisting clients in the use of search engines to acquire customers. Digital Impact contracts with third-party providers to deliver names of individuals who opt-in to join the client’s email list or, in the use of search, to deliver specific content in response to user search queries. Digital Impact is obligated to make payments to third-parties for the cost of services associated with the execution of List Rental, ProspectNet and search engine marketing programs. Digital Impact accounts for revenues and costs associated with Customer Acquisition programs in accordance with Emerging Issues Task Force Issue No. 99-19 (EITF 99-19), “Reporting Revenue Gross as a Principal versus Net as an Agent.” The costs of Customer Acquisition campaigns are estimated using work order commitments when final vendor invoices have not been received. The costs of Customer Acquisition campaigns are recognized in the period that the programs are executed and are netted against program revenue.

     Digital Impact recognizes revenue net of third-party costs because the majority of client and supplier contracts have the following characteristics: the supplier, not the Company, is the primary obligor in the arrangement, the Company has limited latitude in establishing the price charged to the client, the Company’s credit risk is sometimes mitigated by receiving prepayment or reduced credit terms from its clients before ordering from the supplier, the Company does not maintain any inventory related to Customer Acquisition programs, the Company does not make changes to any data acquired from the supplier, and the client approves the supplier selection and the service specifications.

     Digital Impact provides other complementary services to clients, such as strategy, solutions engineering, web-page development, creative design and data analytics. These services are typically billed on an hourly rate or as a fixed project price. The revenue for engagements that support the delivery of future products and services, such as custom solutions, is deferred at the time of delivery and recognized pro-rata over the future periods of usage. The period over which the revenue is recognized varies, generally between one and twelve months, depending on the term of the contract or the estimated period of usage. Management uses its best estimates to determine the appropriate period for revenue deferral.

     We assess probability of collection based on a number of factors, including our past transaction history with the customer and the credit-worthiness of the customer. New customers and certain existing customers are subject to a credit review process that evaluates the customers’ financial position and ultimately their ability to pay according to the original terms of the arrangement. Based on our review process, if it is determined from the outset or during the term of

15


Table of Contents

an arrangement that collection of the resulting receivable is not reasonably assured, then revenue is recognized on a cash-collected basis.

     Allowance for doubtful accounts. The preparation of financial statements requires our management to make estimates and assumptions that affect the reported amount of assets and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reported period. Specifically, management must make estimates of the uncollectable portion of our accounts receivable. Management specifically analyzes accounts receivable and analyzes historical bad debt experience, customer account disputes, customer credit worthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. Our accounts receivable balance was $7.8 million, net of allowance for doubtful accounts of $274,000, as of June 30, 2004.

     Accounting for internal-use software. We account for internal-use software in accordance with AICPA Statement of Position 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.” Internal-use software costs, including any fees paid to third parties to implement the software, are capitalized beginning when we have determined various factors are present, including among others, that the technology exists to achieve the performance requirements, we have made a decision as to whether we will purchase the software or develop it internally and we have authorized funding for the project. Capitalization of software costs ceases when the software implementation is substantially complete and is ready for its intended use, and the capitalized costs are amortized over the software’s estimated useful life (generally two years) using the straight-line method. The estimated useful life is based on technical and marketing management judgment as to the product or feature life cycle. For the three months ended June 30, 2004, we capitalized $17,000 related to internal-use software costs, none of which has been subject to amortization based upon deployment dates of the related products.

     When events or circumstances indicate the carrying value of internal use software might not be recoverable, we assess the recoverability of these assets by determining whether the amortization of the asset balance over its remaining life can be recovered through undiscounted future operating cash flows. The amount of impairment, if any, is recognized to the extent that the carrying value exceeds the projected discounted future operating cash flows and is recognized as a write down of the asset. In addition, if it is no longer probable that computer software being developed will be placed in service, the asset will be adjusted to the lower of its carrying value or fair value, if any, less direct selling costs. Any such adjustment would result in an expense in the period recorded, which could have a material adverse effect on our Consolidated Statement of Operations. As of June 30, 2004, we believe that no such impairment of internal-use software existed.

     Valuation of long-lived assets and goodwill. We assess the impairment of identified intangibles, long-lived assets and goodwill annually and whenever events or a change in circumstances indicate the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following:

  significant underperformance relative to expected historical or projected future operating results;
 
  significant changes in the manner of our use of the acquired assets or the strategy for our overall business;
 
  significant negative industry or economic trends;
 
  significant decline in our stock price for a sustained period of time; and
 
  our market capitalization relative to net book value.

     When we determine that the carrying value of intangible assets, long-lived assets or goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment, we measure any potential impairment based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model. Long-lived assets and goodwill amounted to $7.8 million as of June 30, 2004.

     Accounting for Stock-Based Compensation. The Company accounts for stock-based awards to employees and directors using the intrinsic value method of accounting in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB No. 25). Under the intrinsic value method, because the exercise price of the Company’s employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized in the Company’s Consolidated Statement of Operations. We believe this method is appropriate for the Company because it avoids the volatility of other expense methods which determine stock compensation expense typically by using the Black-Scholes option pricing model which was developed for use in

16


Table of Contents

estimating the value of traded options that have no vesting restrictions and are fully transferable. In addition, option pricing models require input of highly subjective assumptions including the expected stock price volatility.

     We have currently elected to apply the disclosure-only provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” In accordance with the provisions of SFAS No. 123, the Company applies APB No. 25, and related interpretations in accounting for its stock option plans. On March 31, 2004, the FASB issued a proposed Statement, “Share-Based Payment, an amendment of FASB Statements Nos. 123 and 95.” The proposed statement would eliminate the ability to account for share-based compensation transactions using APB No. 25 and generally would require that such transactions be accounted for using a fair-value-based method and recognized as expenses in our consolidated statement of operations. Should this proposed statement be finalized in its current form, it will have a significant impact on our consolidated statement of operations.

17


Table of Contents

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 Ended
    June 30,
    2004
  2003
Net Revenues:
                               
Email marketing
  $ 7,578       73 %   $ 7,534       69 %
Agency services
    2,833       27 %     3,394       31 %
 
   
 
     
 
     
 
     
 
 
Total net revenues
    10,411       100 %     10,928       100 %
 
   
 
     
 
     
 
     
 
 
Cost of revenues:
                               
Email marketing
    3,601       34 %     3,114       29 %
Agency services
    1,534       15 %     1,674       15 %
 
   
 
     
 
     
 
     
 
 
Cost of revenues
    5,135       49 %     4,788       44 %
 
   
 
     
 
     
 
     
 
 
 
   
 
     
 
     
 
     
 
 
Gross profit
    5,276       51 %     6,140       56 %
 
   
 
     
 
     
 
     
 
 
Operating expenses:
                               
Research and development
    984       9 %     1,454       13 %
Sales and marketing
    3,384       33 %     3,051       28 %
General and administrative
    1,820       17 %     1,713       16 %
Amortization of purchased intangibles
          0 %     161       1 %
 
   
 
     
 
     
 
     
 
 
Total operating expenses
    6,188       59 %     6,379       58 %
 
   
 
     
 
     
 
     
 
 
Loss from operations
    (912 )     (9 %)     (239 )     (2 %)
Other income and (expense), net
    28       1 %     (54 )     (1 %)
 
   
 
     
 
     
 
     
 
 
Net loss
  $ (884 )     (8 %)   $ (293 )     (3 %)
 
   
 
     
 
     
 
     
 
 

Three Months Ended June 30, 2004 and 2003

Revenues

     Our Email Marketing business provides clients with comprehensive solutions for creating and executing online direct marketing programs. Our solutions are designed to enable marketers to drive revenue and deepen customer relationships with a comprehensive process that includes: collecting and managing customer information, analyzing the information to determine optimal segments and offers, and delivering highly relevant, individualized email messages. Email Marketing represented 73% and 69% of revenue for the three months ended June 30, 2004 and 2003, respectively.

     The Agency Services group provides expertise to enhance marketing programs and improve results. Digital Impact offers clients services in each of the following categories: Strategic Marketing, Search and Acquisition Services, Creative Services, Web Development, Data Management, Measurement and Analytics, Campaign Automation, and Program Delivery. Agency Services represented 27% and 31% of revenue for the three months ended June 30, 2004 and 2003, respectively.

     Total revenues decreased by 5% to $10.4 million for the three months ended June 30, 2004 from $10.9 million for the three months ended June 30, 2003. The decrease was primarily due to $560,000 decrease in Acquisition Services revenues. An 8% increase in email volume was offset by price erosion and client mix.

Cost of Revenues

     Cost of revenues consists primarily of expenses relating to the delivery of online direct marketing services, including personnel costs of our Email Marketing and Agency Services staff, the amortization of equipment, purchased and licensed technology, data center expenses and software and hardware maintenance costs.

18


Table of Contents

     Total cost of revenues increased 7% to $5.1 million for the three months ended June 30, 2004 from $4.8 million for the three months ended June 30, 2003. The increase in cost of revenues was primarily related to an increase in personnel costs, resulting primarily from higher headcount in Agency Services.

     Gross margin decreased to 51% for the three months ended June 30, 2004 from 56% for the three months ended June 30, 2003. The decline in gross margin was due to a 7% increase in cost of revenues while revenue decreased by 5%. Gross margin for Email Marketing was 52% and 59% for the three months ended June 30, 2004 and 2003, respectively. The decrease in gross margin for Email Marketing is primarily the result of price erosion and client mix. Gross margin for Agency Services was 46% and 51% for the three months ended June 30, 2004 and 2003, respectively. This decline is primarily due to a lower mix of Customer Acquisition revenues.

     We expect that total gross margins for fiscal year 2005 will be about 50%, as we expand our agency services capabilities in strategic marketing, data analytics and search engine marketing.

Operating 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 each operating category, some expenditures, such as compensation, employee benefits, recruiting costs, travel and entertainment costs, facilities costs, third-party professional service fees and non-cash stock-based compensation, occur in each of these categories.

     Stock-based compensation was $28,000 and $25,000 for the three months ended June 30, 2004 and 2003, respectively. For the quarter ended June 30, 2004, stock-based compensation is included in general and administrative expenses. For the quarter ended June 30, 2003, stock-based compensation was included in general and administrative expenses, research and development expenses and cost of revenue.

     We allocate the facilities costs to each functional area based on each area’s 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 amortization of purchased intangibles, goodwill impairment charges and restructuring charges.

     Research and Development. Research and development expenses consist primarily of personnel and related costs, consultants and outside contractor costs. Research and development expenses declined by 32% to $1.0 million for the quarter ended June 30, 2004 from $1.5 million for the quarter ended June 30, 2003. The decline is primarily a result of a $334,000 reduction in personnel costs, resulting from lower headcount driven by the closure of two facilities and a $106,000 decrease in relocation expenses. We capitalized $17,000 and $123,000 for internally developed software for the three months ended June 30, 2004 and 2003, respectively. Research and development expense is substantially dependent on the level of development activity and related staffing.

     Sales and Marketing. Sales and marketing expenses consist of personnel and related costs for our direct sales force and marketing staff, and marketing programs, which include trade shows, advertisements, promotional activities and media events. Sales and marketing expenses increased 11% to $3.4 million for the three months ended June 30, 2004 from $3.1 million for the three months ended June 30, 2003. The increase was mainly attributable to an increase in personnel costs due to higher staffing in account management. During the fiscal year ending March 31, 2005, we expect sales and marketing expenses to increase modestly as a result of higher staffing and allocated overhead.

19


Table of Contents

     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 increased 6% to $1.8 million for the three months ended June 30, 2004, from $1.7 million for the three months ended June 30, 2003. The increase was primarily due to higher fees and increased accounting and legal activities. During the fiscal year ending March 31, 2005, we expect general and administrative expenses to increase slightly in absolute dollars and as a percentage of revenue.

     Amortization of Purchased Intangibles. Amortization of purchased intangibles consists of the amortization of purchased technology from our July 2000 acquisition of MineShare. Amortization of purchased intangibles was $161,000 for the three months ended June 30, 2003. As of September 30, 2003 all purchased intangibles have been fully amortized.

     Other Income and (expense). Other income and (expense) was $28,000 for the three months ended June 30, 2004, compared to ($54,000) for the three months ended June 30, 2003. Other income relates to interest income on cash, cash equivalents and short-term investments. Other expenses relate primarily to interest paid on leases and debt and losses on disposals of fixed assets. Other expenses decreased as a result of a decline in interest paid on long-term debt and paying-off the equipment leases.

     Income taxes. No provision for federal and state income taxes was recorded as we incurred net operating losses from inception through June 30, 2004. Due to the uncertainty regarding the ultimate utilization of the net operating loss carryforwards, we have not recorded any benefit for losses and a valuation allowance has been recorded for the entire amount of the net deferred tax asset. The Tax Reform Act of 1986 limits the use of net operating loss and tax credit carryforwards in certain situations where changes occur in the stock ownership of a company. If we should have an ownership change, as defined for tax purposes, utilization of the carryforwards could be restricted. In addition, sales of our stock, including shares sold in the initial public offering, may further restrict our ability to utilize our net operating loss carryforwards.

20


Table of Contents

Liquidity and Capital Resources

Cash and Investments.

     As of June 30, 2004, we had $25.8 million in cash, cash equivalents and short-term investments and working capital of $29.6 million. In addition, as of June 30, 2004, we had $1.2 million in restricted cash, $1.1 million of which is supporting letters of credit issued against certain contractual lease obligations.

Cash Flow from Operating Activities.

     For the three months ended June 30, 2004 our operating activities used $275,000 of cash compared to $2.5 million of cash generated by the operating activities for the three months ended June 30, 2003. Net cash used by operating activities for the three months ended June 30, 2004 consisted of the net loss of $884,000 and non-cash items of $1.1 million, offset by a $522,000 decrease in cash arising from changes in assets and liabilities, primarily as a result of decreases in deferred revenue and accrued liabilities and payroll, partially offset by a decrease in accounts receivable. Cash provided by operating activities for the three months ended June 30, 2003 resulted from the net loss of $293,000, offset by non-cash items of $1.5 million, and an increase in cash of $1.3 million arising from changes in operating assets and liabilities, primarily as a result of decreases in accounts receivable and increases in accounts payable offset by increases in prepaid expenses and other current assets and decreases in accrued liabilities, accrued payroll and deferred revenue.

Cash Flow from Investing Activities.

     Our investing activities used net cash of $19,000 for the three months ended June 30, 2004 compared to $1.7 million used by investing activities for the three months ended June 30, 2003. Net cash used in investing activities for the three months ended June 30, 2004 primarily related to acquisitions of property and equipment totaling $522,000, offset by maturities of marketable securities of $500,000. Net cash used in investing activities for the three months ended June 30, 2003 was attributable to acquisitions of property and equipment totaling $745,000 and purchases of short-term investments totaling $1.0 million.

Cash Flow from Financing Activities.

     For the three months ended June 30, 2004, our financing activities provided net cash of $473,000 compared to net cash of $334,000 provided by financing activities for the three months ended June 30, 2003. Net cash provided by financing activities for the three months ended June 30, 2004 consisted of proceeds from option exercises and employee stock plan purchases totaling $554,000, offset by principal payments on long-term debt of $81,000. Net cash provided by financing activities for the three months ended June 30, 2003 was attributable primarily to the proceeds from option exercises and employee stock plan purchase totaling $813,000, offset by principal payments on long-term debt totaling $464,000 and purchases of treasury stock totaling $15,000.

Debt Payments.

     At June 30, 2004 we had borrowings in the form of long-term debt, payable in quarterly installments through April 2006. Total debt as of June 30, 2004 was $507,000, with $308,000 bearing an interest rate of 3% and $199,000 bearing an interest rate of 2%.

Commitments.

     We are committed to making cash payments in the future on our purchase obligations, notes payable and non-cancelable operating leases. We have no off-balance sheet debt or other such unrecorded obligations and we have not guaranteed the debt of any other party. Our credit agreements place restrictions on our ability to pay dividends.

Future Cash Needs.

     Digital Impact has made certain commercial commitments that extend beyond our fiscal year ending March 31, 2005. These commitments include letters of credit obtained from a financial institution in lieu of a security deposit for leased office space. The aggregate amount of the letters of credit is classified as restricted cash.

21


Table of Contents

Below is a schedule of the future payments that we are obligated to make based on agreements in place as of June 30, 2004:

                                                 
            Nine Months    
            Ended   Year Ended March 31,
            March 31,  
    Total
  2005
  2006
  2007
  2008
  2009
    (in thousands)
Contractual Obligations:
                                               
Purchase obligations
  $ 720     $ 321     $ 369     $ 30     $     $  
Long-term debt
    507       249       258                    
Operating leases
    6,964       2,140       2,296       2,324       204        
 
   
 
     
 
     
 
     
 
     
 
     
 
 
Total Contractual Obligations
  $ 8,191     $ 2,710     $ 2,923     $ 2,354     $ 204     $  
 
   
 
     
 
     
 
     
 
     
 
     
 
 

     Our data center is primarily located at facilities operated by Globix Corporation in Northern California. Our agreement with Globix expires in September 2004. As of June 30, 2004, the remaining obligation under the Globix lease is approximately $179,000, which is included in the total operating leases amount in the table above.

     On July 9, 2004, we entered into an operating lease agreement in connection with the office space rented by Marketleap. The future payments that we are obligated to make based on this agreement are as follows: $30,000 for the nine months ended March 31, 2005, $50,000 for the fiscal year 2006 and $17,000 for the fiscal year 2007.

     The Company continues to face risks associated with the execution of its strategy. Our future cash flows and capital requirements depend on numerous factors, including market acceptance of our services, competition from new and existing competitors, the amount of resources we invest in our data center infrastructure and new product development, marketing and selling our products and services, our brand promotions and any future acquisitions or divestitures.

     The Company’s primary source of liquidity is $25.8 million in cash and cash equivalents, and short-term investments. The Company believes it has the necessary financial resources to fund its working capital needs, capital expenditures and other business requirements for at least the next 12 months.

Indemnification Provisions.

     During the ordinary course of business, we have included indemnification provisions within our contracts. Pursuant to these agreements, we indemnify, hold harmless, and agree to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally parties with which we have commercial relations, arising from a breach of representations, warranties or covenants and infringement of a 3rd parties’ intellectual property rights. To date, we have not incurred any costs in connection with such indemnification clauses.

Recent Accounting Pronouncements

     On March 31, 2004, the FASB issued a proposed Statement, “Share-Based Payment, an amendment of FASB Statements Nos. 123 and 95,” that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for either equity instruments of the enterprise or, liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. The proposed statement would eliminate the ability to account for share-based compensation transactions using Accounting Principles Board, or APB, Opinion No. 25, “Accounting for Stock Issued to Employees,” and generally would require that such transactions be accounted for using a fair-value-based method and recognized as expenses in our consolidated statement of income. The proposed standard would require the modified prospective method be used, which would require that the fair value of new awards granted from the beginning of the year of adoption plus unvested awards at the date of adoption be expensed over the vesting period. In addition, the proposed statement encourages companies to use the “binomial” approach to value stock options, which differs from the Black-Scholes option pricing model that we currently use to determine the fair value of our options. The proposed standard is recommending that the effective date for public companies be fiscal years beginning after December 15, 2004. Should this proposed statement be finalized in its current form, it will have a significant impact on our consolidated statement

22


Table of Contents

of operations as we will be required to expense the fair value of our stock options rather than disclosing the impact on our consolidated net loss within our notes as is our current practice.

23


Table of Contents

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.

We derive our revenue from marketing services, which revenues tend to be cyclical and dependent on the economic prospects of our clients and the economy in general. A sustained reduction in expenditures by our clients or a sustained downturn in the economy could cause our revenues to decline significantly in any given period.

     Our clients’ marketing and advertising expenditures tend to be cyclical, reflecting overall economic conditions as well as budgeting and buying patterns. The overall market for marketing and advertising services, including Internet marketing and advertising services, has experienced lower prices in recent quarters. We also cannot assure you that if economic conditions improve, marketing budgets and advertising spending will increase from current levels. A continued decline in the economic prospects of our clients or the economy in general could alter pending priorities or increase the time it takes to close a sale with a prospective client. As a result, our revenues from marketing services may decline significantly in any given period.

We may not be able to forecast our revenues accurately because our customers’ marketing budgets are difficult to predict and may fluctuate from period to period.

     Our revenue and operating results depend upon the marketing budgets of our existing and new customers. These marketing budgets are difficult to predict and may vary from period to period as a result of factors that are beyond our control, including our customers’ marketing objectives for a particular period, the general state of the economy and our customers’ success in the marketplace. Consequently, we face difficulty in predicting the amount of revenues each client will generate in any particular quarter. 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. We believe our business is affected by similar revenue fluctuations, but our limited operating history is insufficient to isolate and predict the magnitude of these effects. 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

24


Table of Contents

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 only two clients each accounted for more than 10% of our revenues for the three months ended June 30, 2004, the loss of one of these clients or another major client could have a material adverse effect on our business and 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 DoubleClick, Responsys, Experian, Silverpop, Bigfoot Interactive, InfoUSA, ExactTarget and SmartDM as well as the in-house information technology departments of our existing and prospective clients. The loss of a client due to service quality or technology problems could result in reputational harm to us and, as a result, increase the effect of competition and negatively impact our ability to attract new 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 possessing 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 fail to respond to changing customer preferences in our market, demand for our technology and services may decline, causing our revenues to suffer.

     If we do not continue to develop new technology and services that keep pace with competitive developments, satisfy diverse and rapidly evolving customer requirements and achieve market acceptance, we might be unable to attract new customers and retain existing customers. The development of proprietary technology and service enhancements and the migration of customers to this new technology entail significant technical and business risks and requires substantial expenditures and lead-time. We might not be successful in marketing and supporting recently released versions of our technology and services on a timely or cost-effective basis. In addition, even if new technology and services are developed and released, they might not achieve market acceptance. We have experienced delays in releasing new or enhanced technology and services in the past and could experience similar delays in the future, which could cause us to lose customers. Also, if we are not successful in a smooth migration of our customers to our new or enhanced technology and services, we could lose customers.

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 products and services and our ability to provide comprehensive online direct marketing expertise. Our main offices are located in the San Francisco Bay Area and New York City, where competition for personnel with Internet-related technology and marketing skills has traditionally been intense. In addition, we restructure our organization from time to time, including reductions in our workforce, to streamline operations and reduce costs. These measures may have unanticipated consequences, such as low morale, unexpected litigation and difficulty in future employee hiring and retention. 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.

If the delivery of our email messages is limited or blocked, then the amount we may be able to charge our clients for producing and sending their campaigns may be reduced and 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

25


Table of Contents

to recipients in major corporations. In particular, a significant percentage of our emails are sent to recipients who use AOL. We do not have, nor are we required to have, an agreement with AOL to deliver emails to their customers. AOL 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, AOL and other Internet service providers are able to block messages from reaching their users. Recent releases of Internet service provider software and the implementation of stringent new policies by Internet service providers have caused periodic temporary blockages of our ability to successfully deliver emails to their customers. We continually improve our own technology and work with Internet service providers to improve our ability to successfully deliver our emails. However, if Internet service providers materially 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 the amount we may be able to charge our clients for producing and sending their online direct marketing campaigns may be reduced and our clients may discontinue their use of our services. In addition, the effectiveness of email marketing may decrease as a result of increased consumer resistance to email marketing in general.

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, subject to applicable insurance coverage, 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 protect our intellectual property or if third parties develop superior intellectual property, third parties could use our intellectual property without our consent and prevent us from using their technology.

     Our ability to successfully compete is substantially dependent upon our internally developed technology and intellectual property, which we protect through a combination of patent, copyright, trade secret and trademark law, as well as contractual obligations. We have one issued U.S. patent and have three U.S. patent applications pending. We have several registered trademarks in the U.S. and Japan and have several more applications pending in the U.S., Europe and Japan. We may not be able to 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.

     We are one of several companies rapidly building new technologies in our industry. It is possible that a third party could be awarded a patent that applies to some portion of our technology. If this occurs, we may be required to incur substantial legal fees, cease using the technology or pay significant licensing fees for such use.

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.

26


Table of Contents

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. 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 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.

     Congress recently enacted the CAN-SPAM Act of 2003, legislation that regulates the sending of commercial email. This legislation pre-empts state laws regulating commercial email. The effect of this legislation on marketers is difficult to predict. We cannot assure you that this or future legislation regarding commercial email will not harm our business. Moreover, list rental and other types of affiliate marketing programs must be modified to comply with certain aspects of CAN-SPAM. Some of these modifications may add to the cost of conducting these types of programs. As a result, there may be a decline in our Customer Acquisition revenues.

     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 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 our operating performance and may accordingly reduce the price of our common stock without regard to our operating performance.

If our independent auditor is unable to provide us with an unqualified report as to the adequacy of our internal controls over financial reporting as required by Section 404 of the Sarbanes-Oxley Act of 2002, investors could lose confidence in the reliability of our financial statements, which could result in a decrease in the value of our common stock.

     As directed by Section 404 of the Sarbanes-Oxley Act of 2002, the Securities and Exchange Commission adopted rules requiring us to include a report of management on our internal controls over financial reporting in our annual reports on Form 10-K that contains an assessment by management of the effectiveness of our internal controls over financial reporting. In addition, beginning in either March 2005 or March 2006, the public accounting firm auditing our financial statements must attest to and report on management’s assessment of the effectiveness of our internal controls over financial reporting. If we fail to implement adequate controls, or if our independent auditors are not satisfied with our internal controls over financial reporting or with the level at which these controls are documented, operated or reviewed, they may decline to attest to management’s assessment or may issued a qualified report. This could result in an adverse reaction in the financial markets due to a loss of confidence in the reliability of our financial statements, which could cause the market price of our shares to decline.

We may not realize expected benefits from our recent acquisition.

     We expect our recent acquisition of Marketleap to, among other things, result in additional net revenues for fiscal year 2005 and enhance our robust integrated marketing solutions. Achieving the benefits of our recent acquisition of Marketleap will depend in part on our integration of its technology, operations and personnel, and our demonstration

27


Table of Contents

to customers that the acquisition will not result in adverse changes in client service standards. In this regard, we may be required to spend additional time or money on integration, which would otherwise be spent on developing our own business and services. It is not certain that we can successfully complete the required integration in a timely manner, or at all, or that any of the anticipated benefits of the acquisition will be realized. If we do not integrate the technology and operations effectively or if management spends too much time on integration issues, it could harm our business, financial condition and operating results.

     With respect to the integration of personnel, despite our efforts to retain the key employees of Marketleap, we may not be successful, as competition for qualified management and technical employees in our industry is intense, and we may have a different corporate culture and these key employees may not want to work for a larger, publicly-traded company. In addition, competitors may recruit these key employees during the integration process, as is common in technology acquisitions. As a result, these key employees could leave with little or no prior notice, which could impede the integration process and harm our business, financial condition and operating results. In this regard, in connection with the acquisition certain key employees have entered into employment and non-competition agreements which will restrict their ability to compete with us if they leave. We cannot assure you of the enforceability of these non-competition agreements or that these employees will continue to work with us under their employment agreements.

If we acquire additional companies or technologies in the future, they could prove difficult to integrate, disrupt our business, dilute stockholder value or adversely affect our operating results.

     In addition to the acquisition that we have recently completed, we may acquire or make investments in other complementary companies, services and technologies in the future. If we fail to properly evaluate and execute acquisitions and investments, they may seriously harm our business and prospects. To successfully complete an acquisition, we must:

  properly evaluate the business, personnel and technology of the company to be acquired;
 
  accurately forecast the financial impact of the transaction, including accounting charges and transaction expenses;
 
  integrate and retain personnel;
 
  combine potentially different corporate cultures;
 
  effectively integrate products and research and development, sales, marketing and support operations; and
 
  maintain focus on our day-to-day operations.

     Further, the financial consequences of our acquisitions and investments may include potentially dilutive issuances of equity securities, one-time write-offs, amortization expenses related to goodwill and other intangible assets and the incidence of contingent liabilities.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Interest Rate Risk

     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 use derivative financial instruments in our investment portfolio. We ensure the safety and preservation of our invested principal funds by limiting default risk, market risk and reinvestment risk. We mitigate default risk by investing in high quality securities.

Foreign Currency Risk

     For the period from our inception through June 30, 2004, we provided our services to clients primarily in the United States. As a result, our financial results have not been materially 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. We have a subsidiary in the United Kingdom which, to date, has had minimal operations

28


Table of Contents

and minimal foreign currency sales. The effect of foreign exchange rates fluctuations on operations were not material for the three months ended June 30, 2004 and 2003, respectively.

     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. As of June 30, 2004, we had $132,000 in cash and cash equivalents denominated in foreign currencies.

Item 4. Controls and Procedures

     As of the end of the period covered by this report, the Company conducted an evaluation, under the supervision and with the participation of the principal executive officer and principal financial officer, of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)). Based on this evaluation, the principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures are effective, as of the end of the period covered by this report, to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. There was no change in the Company’s internal control over financial reporting during the Company’s most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

     In June 2001, a series of putative securities class actions were filed in United States District Court for the Southern District of New York against certain investment bank underwriters for the Company’s initial public offering (“IPO”), the Company, and various of the Company’s officers and directors. The complaints, which have been consolidated under the caption In re Digital Impact, Inc. Initial Public Offering Securities Litigation, Civil Action No. 01-CV-4942, allege undisclosed and improper practices concerning the allocation of the Company’s IPO shares, in violation of the federal securities laws, and seek unspecified damages on behalf of persons who purchased the Company’s stock during the period from November 22, 1999 to December 6, 2000. The Court has appointed a lead plaintiff for the consolidated cases. On April 19, 2002, plaintiffs filed an amended complaint. Other actions have been filed making similar allegations regarding the IPOs of more than 300 other companies. All of these lawsuits have been coordinated for pretrial purposes as In re Initial Public Offering Securities Litigation, Civil Action No. 21-MC-92. Defendants in these cases filed omnibus motions to dismiss on common pleading issues. Oral argument on these omnibus motions to dismiss was held on November 1, 2002. The Company’s officers and directors have been dismissed without prejudice in this litigation. On February 19, 2003, the court granted in part and denied in part the omnibus motion to dismiss. The court’s order did not dismiss any claims against the Company.

     A stipulation of settlement for the claims against the issuer-defendants, including the Company, has been submitted to the court. The settlement is subject to a number of conditions, including approval of the court. If the settlement does not occur, and litigation against the Company continues, the Company believes it has meritorious defenses and intends to defend the case vigorously. The outcome of this litigation is uncertain and no estimate of liability can be made at this time.

     On February 23, 2004, the Company filed a patent infringement lawsuit against Responsys, Inc., a competitor of the Company. The lawsuit, captioned Digital Impact, Inc. v. Responsys, Inc., N. D. Cal., Case No. C04 00734 (SBA), alleges that Responsys has infringed and is continuing to infringe the Company’s U.S. Patent No. 6,449,634. The complaint seeks injunctive relief and unspecified damages. Responsys filed an answer and counterclaim on March 15, 2004. The counterclaim seeks a declaration that the patent is invalid or, in the alternative, that Responsys’s technology does not infringe the patent. The Company replied to the counterclaim on April 7, 2004, denying all material allegations. Responsys then filed a motion for judgment on the pleadings, which was denied on June 4, 2004.

Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

There were no purchases of equity securities during the quarter covered by this report.

Item 3. Defaults Upon Senior Securities

Not applicable.

29


Table of Contents

Item 4. Submission of Matters to a Vote of Security Holders

Not applicable.

Item 5. Other Information

Not applicable.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

a)   Exhibits
     
Exhibit No.
  Description

 
 
 
2.1(2)
  Agreement and Plan of Merger and Reorganization by and among Digital Impact, Inc., Marketleap.com, Inc., Jumper Acquisition Corporation, Noel McMichael, Paul Owen and Noel McMichael as Shareholder Representative, dated July 10, 2004.
 
   
10.1(3)
  The Registrant’s 1998 Stock Plan, as amended and restated
 
   
10.2(1)
  The Registrant’s 1999 Employee Stock Purchase Plan
 
   
10.3(8)
  The Registrant’s 1999 Director Equity Plan, as amended and restated
 
   
10.4(1)
  Employment Agreement between the Registrant and David Oppenheimer
 
   
10.5(5)
  Employment Agreement between the Registrant and Kevin Johnson
 
   
10.6(6)
  Standard Form Lease between the Registrant and Casiopea Venture Corporation
 
   
10.7(1)
  Form of Indemnification Agreement between the Registrant and each of its directors and executive officers
 
   
10.8(4)
  Form of Retention Agreement with Key Employees
 
   
10.9(6)
  Retention Agreement between the Registrant and William Park dated January 11, 2002
 
   
10.10(6)
  Retention Agreement between the Registrant and Gerardo Capiel dated January 11, 2002
 
   
10.11(6)
  Promissory Note of William Park dated February 7, 2002
 
   
10.12(7)
  Amendment to Retention Agreement between the Registrant and William Park dated December 23, 2002
 
   
10.13(7)
  Amendment to Retention Agreement between the Registrant and Gerardo Capiel dated December 23, 2002
 
   
10.14(9)
  Transition Agreement and Release by and between the Registrant and Dave Kleinberg dated February 10, 2003
 
   
10.15(10)
  Master Service Agreement between the Registrant and Globix Corporation dated September 25, 2002
 
   
31.1
  Certification of Chief Executive Officer, as required by Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934.
 
   
31.2
  Certification of Chief Financial Officer, as required by Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934.
 
   
32.1
  Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
   
32.2
  Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(1)   Incorporated by reference to Digital Impact’s registration statement on Form S-1 (SEC File No. 333-87299) originally filed with the Commission on September 17, 1999, as subsequently amended.
 
(2)   Incorporated by reference to Digital Impact’s Current Report on Form 8-K filed with the Commission on July 12, 2004.
 
(3)   Incorporated by reference to Digital Impact’s Registration Statement on Form S-8 (SEC File No. 333-67686) filed with the Securities and Exchange Commission

30


Table of Contents

on August 16, 2001.

(4)   Incorporated by reference to Digital Impact’s Report on Form 10-K filed with the Commission on June 13, 2001.
 
(5)   Incorporated by reference to Digital Impact’s Report on Form 10-Q filed with the Commission on February 14, 2002.
 
(6)   Incorporated by reference to Digital Impact’s Report on Form 10-K filed with the Commission on June 7, 2002.
 
(7)   Incorporated by reference to Digital Impact’s Report on Form 10-Q filed with the Commission on February 14, 2003.
 
(8)   Incorporated by reference to Digital Impact’s Proxy Statement on Schedule 14A filed with the Commission on June 24, 2003.
 
(9)   Incorporated by reference to Digital Impact’s Report on Form 10-K filed with the Commission on June 13, 2003.
 
(10)   Incorporated by reference to Digital Impact’s Report on Form 10-K filed with the Commission on June 14, 2004.

b)   Reports on Form 8-K

On April 5, 2004, Digital Impact furnished a Current Report on Form 8-K with the Securities and Exchange Commission announcing our projected financial results for the fiscal fourth quarter ended March 31, 2004.

On April 27, 2004, Digital Impact furnished a Current Report on Form 8-K with the Securities and Exchange Commission announcing our financial results for the fiscal fourth quarter and full year ended March 31, 2004.

On July 12, 2004, Digital Impact furnished a Current Report on Form 8-K with the Securities and Exchange Commission announcing that Digital Impact has entered into an agreement to acquire Marketleap.com, Inc. and announcing certain financial information related to the results of operations for the fiscal quarter ended June 30, 2004.

On July 22, 2004, Digital Impact furnished a Current Report on Form 8-K with the Securities and Exchange Commission. The Current Report on Form 8-K includes a copy of our press release dated July 22, 2004 reporting our results of operations and financial condition for the quarter ended June 30, 2004.

31


Table of Contents

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.

     
Dated: August 12, 2004
  DIGITAL IMPACT, INC.
  (Registrant)
 
   
  /S/ WILLIAM PARK
 
  William Park
  President, Chief Executive Officer and Director
  (Principal Executive Officer)
 
   
  /S/ DAVID OPPENHEIMER
 
  David Oppenheimer
  Sr. Vice President, Chief Financial
  Officer and Treasurer
  (Principal Financial and Accounting Officer)

32


Table of Contents

Exhibit Index

     
Exhibit No.
  Description

 
 
 
2.1(2)
  Agreement and Plan of Merger and Reorganization by and among Digital Impact, Inc., Marketleap.com, Inc., Jumper Acquisition Corporation, Noel McMichael, Paul Owen and Noel McMichael as Shareholder Representative, dated July 10, 2004.
 
   
10.1(3)
  The Registrant’s 1998 Stock Plan, as amended and restated
 
   
10.2(1)
  The Registrant’s 1999 Employee Stock Purchase Plan
 
   
10.3(8)
  The Registrant’s 1999 Director Equity Plan, as amended and restated
 
   
10.4(1)
  Employment Agreement between the Registrant and David Oppenheimer
 
   
10.5(5)
  Employment Agreement between the Registrant and Kevin Johnson
 
   
10.6(6)
  Standard Form Lease between the Registrant and Casiopea Venture Corporation
 
   
10.7(1)
  Form of Indemnification Agreement between the Registrant and each of its directors and executive officers
 
   
10.8(4)
  Form of Retention Agreement with Key Employees
 
   
10.9(6)
  Retention Agreement between the Registrant and William Park dated January 11, 2002
 
   
10.10(6)
  Retention Agreement between the Registrant and Gerardo Capiel dated January 11, 2002
 
   
10.11(6)
  Promissory Note of William Park dated February 7, 2002
 
   
10.12(7)
  Amendment to Retention Agreement between the Registrant and William Park dated December 23, 2002
 
   
10.13(7)
  Amendment to Retention Agreement between the Registrant and Gerardo Capiel dated December 23, 2002
 
   
10.14(9)
  Transition Agreement and Release by and between the Registrant and Dave Kleinberg dated February 10, 2003
 
   
10.15(10)
  Master Service Agreement between the Registrant and Globix Corporation dated September 25, 2002
 
   
31.1
  Certification of Chief Executive Officer, as required by Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934.
 
   
31.2
  Certification of Chief Financial Officer, as required by Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934.
 
   
32.1
  Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
   
32.2
  Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(1)   Incorporated by reference to Digital Impact’s registration statement on Form S-1 (SEC File No. 333-87299) originally filed with the Commission on September 17, 1999, as subsequently amended.
 
(2)   Incorporated by reference to Digital Impact’s Current Report on Form 8-K filed with the Commission on July 12, 2004.
 
(3)   Incorporated by reference to Digital Impact’s Registration Statement on Form S-8 (SEC File No. 333-67686) filed with the Securities and Exchange Commission on August 16, 2001.
 
(4)   Incorporated by reference to Digital Impact’s Report on Form 10-K filed with the Commission on June 13, 2001.
 
(5)   Incorporated by reference to Digital Impact’s Report on Form 10-Q filed with the Commission on February 14, 2002.
 
(6)   Incorporated by reference to Digital Impact’s Report on Form 10-K filed with the Commission on June 7, 2002.
 
(7)   Incorporated by reference to Digital Impact’s Report on Form 10-Q filed with the Commission on February 14, 2003.
 
(8)   Incorporated by reference to Digital Impact’s Proxy Statement on Schedule 14A filed with the Commission on June 24, 2003.
 
(9)   Incorporated by reference to Digital Impact’s Report on Form 10-K filed with the Commission on June 13, 2003.
 
(10)   Incorporated by reference to Digital Impact’s Report on Form 10-K filed with the Commission on June 14, 2004.