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

Form 10-Q

SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended May 31, 2004
Commission File Number: 0-17932

Interland, Inc.

303 Peachtree Center Avenue, Suite 500, Atlanta, GA 30303
(Address, including Zip Code, of principal executive offices)

(404) 720-8301
(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $.01 per share
Registered on The Nasdaq National Market

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, 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 Act). Yes [x] No [  ]

The number of outstanding shares of the registrant’s Common Stock on June 30, 2004 was 16,080,805.

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PART I. Financial Information

Item 1. Financial Statements

Interland, Inc.
Consolidated Statements Of Operations
(In thousands except per share amounts)
(Unaudited)

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

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Interland, Inc.

Consolidated Balance Sheets
(In thousands)
(Unaudited)

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

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Interland, Inc.

Consolidated Statements of Cash Flows
(In thousands)
(Unaudited)

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

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Interland, Inc.

Notes To Consolidated Financial Statements

1. General

Business — Interland, Inc. together with its subsidiaries (collectively the “Company”), is a leading Web hosting and online services company dedicated to helping small-and-medium-sized businesses (“SMB”) achieve success by providing the knowledge, services and tools to build, manage and promote businesses online. Interland offers a wide selection of online services, including standardized Web hosting, e-commerce, application hosting, Web site development and marketing and optimization tools. Historically, the Company provided a variety of computer products and related services through its PC Systems, SpecTek, and Web hosting business segments. The Company disposed of its PC Systems and SpecTek business segments during the third quarter of fiscal 2001. The Company’s Web hosting business remains as the Company’s sole continuing operation.

History of operating losses —The Company’s Web hosting business has incurred net losses and losses from operations for all but one quarter from inception through the first nine-months of fiscal 2004. The Company’s future success is dependent upon its ability to achieve positive cash flow prior to the depletion of cash resources and its ability to raise funds, if needed. Nonetheless, the Company’s current financial forecast supports management’s expectation that the Company will have adequate cash resources to fund operations for at least the next 12 months.

2. Significant Accounting Policies

Interim Unaudited Financial Information — The accompanying unaudited consolidated financial statements for the three and nine- month periods ended May 31, 2004 and May 31, 2003, have been prepared in accordance with generally accepted accounting principles for interim financial information. In management’s opinion, these statements include all adjustments necessary for a fair presentation of the results of the interim periods shown. All adjustments are of a normal recurring nature unless otherwise disclosed. Operating results for the three and nine-month periods ended May 31, 2004 are not necessarily indicative of the results that may be expected for the full fiscal year.

Basis of Presentation – This report on Form 10-Q (“10-Q”) for the third quarter ended May 31, 2004 should be read in conjunction with the Company’s Annual Report on Form 10-K (“10-K”) for the fiscal year ended August 31, 2003. The financial statements include the accounts of Interland, Inc. and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated.

Stock-based employee compensation — The Company accounts for stock-based compensation issued to employees using the intrinsic value method as prescribed by Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees and has adopted the disclosure requirements of SFAS No. 123 and SFAS 148.

If the Company had elected to adopt the optional recognition provisions of SFAS No. 123, which uses the fair value based method for stock-based compensation, and amortized the fair value of the options to compensation expense on a straight-line basis over the vesting period of the options, the following table illustrates the effect on net loss and loss per share:

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Interland, Inc.
Notes To Consolidated Financial Statements (Continued)

Recently issued accounting standards – In January 2003, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46). FIN 46 clarified the application of Accounting Research Bulletin No. 51, Consolidated Financial Statements, to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated support from other parties. FIN 46 requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. The Company has evaluated its investments and other relationships and concluded that none meets the requirements for consolidation under FIN 46.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” This statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. This statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective for the first quarter of fiscal year 2004. The adoption of this standard on September 1, 2003 did not have a material impact on Interland’s consolidated financial statements.

3. Discontinued Operations

During the third quarter and first nine-months of fiscal 2004, the Company recorded $0.5 million and $1.8 million, respectively, of losses on disposal of discontinued operations primarily in connection with litigation related to the PC Systems business. The Company has several pending claims concerning the intellectual property rights of its discontinued operations and is vigorously defending these claims. The Company expects to incur additional losses from discontinued operations due to the costs of defending these claims. As of May 31, 2004, the Company had an aggregate amount of $1.0 million accrued for such matters.

4. Restructuring And Facility Exit Costs

In March 2004 the Company decided to change its approach to distributing its mainstream market hosting solutions from reliance upon a direct field sales force to an indirect channel approach. Due to this decision, the Company implemented a restructuring program to reduce its cost structure. These restructuring charges include costs of $0.3 million related to lease commitments, and $0.8 million employee severance and benefits. The remaining accruals for these restructuring charges as of May 31, 2004 were $0.3 and $0.1 million, respectively.

During the second quarter of 2003, the Company approved and initiated a program to exit certain facilities and consolidate those operations into other existing facilities. This restructuring plan is part of management’s continued plan to streamline the Company’s operations and to reduce the long-term operating costs. In accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” costs associated with these activities have been recognized and measured at their fair value in the period in which the liabilities are incurred. One-time termination benefits for employees required to render services until they are terminated in order to receive termination benefits were recognized ratably over the future service period. The plan provided for the closure of three data center facilities, a reduction of those related workforces of approximately 171 employees, and the termination of bandwidth and data connectivity contracts in place at these and other facilities. The Company exited all three data centers by June 2003.

During the fourth quarter of 2001, the Company approved and implemented a restructuring program in connection with its acquisition of Interland-Georgia. In accordance with EITF No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity,” the restructuring costs, excluding asset impairments, were recognized as liabilities at the time management committed to the plan. Management determined that these costs provided no future economic benefit, were incremental to other costs incurred by the Company prior to the restructuring, or were contractual obligations that existed prior to the date the plan was approved and were either continued after the exit plan was

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Interland, Inc.
Notes To Consolidated Financial Statements (Continued)

completed with no economic benefit to the Company or could not be cancelled without penalty, and they were incurred as a direct result of the plan to exit the identified activities. The asset impairments were accounted for in accordance with SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of.”

The following table shows a reconciliation of the beginning and ending liability balances from August 31, 2001 through May 31, 2004 related to all restructuring activities recorded by the Company under the restructuring programs described in the above paragraphs. The balance at May 31, 2004 represents the remaining liabilities to be paid in cash:

During the nine-month period ended May 31, 2004 the Company continued to pay down the lease abandonment obligations according to the contractual monthly liability, net of sublease payments received, which the Company believes will continue through 2007. The Company also adjusted its reserves down related to bandwidth contract obligations by $0.4 million as a result of continued negotiations and expects to have complete resolution in fiscal year 2005. The Company also increased its reserves by $0.2 million related to lease abandonment obligations as a result of changes in the Company’s sublease expectations and landlord requirements. The employee termination benefits associated with the termination of the mainstream market direct sales force of $0.8 million, which $0.7 million was paid out by May 31, 2004. The remaining $0.1 million will be paid out in the fourth quarter of this fiscal year.

5. Purchase Business Combination Liabilities

In connection with the acquisitions of Interland-Georgia in fiscal 2001, iNNERHOST in fiscal 2002, and Trellix Corporation in fiscal 2003, the Company accrued certain liabilities representing estimated costs of exiting certain facilities, termination of bandwidth contracts and involuntary termination of employees in accordance with EITF No. 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination.” These amounts are included in “Accrued expenses” on the balance sheet and are not included in the restructuring reserves discussed in Note 3. The following table shows the changes in the accrual from inception to the period ending May 31, 2004:

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Interland, Inc.
Notes To Consolidated Financial Statements (Continued)

During the nine-month period ended May 31, 2004 the Company continued to pay down the lease abandonment obligation according to the contractual monthly liability, net of sublease payments received, which the Company believes will continue through July 2009. The Company made payments on specific obligations included in the business combinations liability of $0.1 million for rent obligations, net of sublease payments received. There were also adjustments of $0.1 million and payments of $0.1 million for benefits paid to specific terminated employees.

6. GOODWILL AND INTANGIBLES

In accordance with the requirements of SFAS 142,“Goodwill and Other Intangible Assets”, the Company tests for impairment on an annual basis and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of goodwill below its carrying amount. During the third quarter of 2004, the Company completed the annual impairment test which entailed comparing the aggregate market value of the Company’s outstanding securities plus its liabilities to the aggregate carrying value of the Company’s assets, including goodwill and other indefinite life intangible assets. The Company’s market price of its stock has experienced significant volatility over the last fiscal year and closed as of May 31, 2003, with a market value significantly less that the value at the beginning of the fiscal year. Management retained valuation specialists to assist in the valuation of its intangible assets for purposes of determining the implied fair value of goodwill at May 31, 2004. Upon completion of the annual assessment, Interland recorded a non-cash impairment charge of $66.6 million to remove the remainder of the carrying value of goodwill.

The following table discloses changes in the carrying amount of goodwill from August 31, 2003 through May 31, 2004:

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Interland, Inc.
Notes To Consolidated Financial Statements (Continued)

During the third quarter of 2004, the Company performed an impairment test pursuant to the guidance provided by SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” Upon completion of the assessment, Interland recorded a non-cash impairment charge of $4.8 million, reducing the carrying value of certain core technology, customer relationships, trademarks and other intangible assets to their new estimated fair values. The following table summarizes intangible assets by asset class and related accumulated amortization:

7. Property, plant and equipment

The Company had invested in certain software to improve its internal customer billing process. During the third quarter 2004, the decision was made to abandon the project and record an impairment charge of $2.2 million against earnings and reduce the capital assets being held in assets in progress, in accordance with the requirements of SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”.

8. Contingencies

In February 2003, the Company filed a lawsuit in Cobb County, Georgia against Mr. Gabriel Murphy, one of the former principals of Interland’s subsidiary, CommuniTech.Net, Inc. (“Communitech”), which was acquired by Interland in February 2002. The Company’s lawsuit claims, among other things, that Mr. Murphy breached certain covenants under his employment agreement and also demands payment from Mr. Murphy’s two promissory notes (one of which was “non-recourse” while the other was “recourse”). In March 2004, Interland retired the 273,526 shares of stock held as collateral and wrote off the $2,000,000 non-recourse promissory note. The other $735,000 full recourse promissory note remains outstanding and continues to be a subject of the Cobb County litigation noted above.

In February 2003 Messrs. Heitman, also a former principal of Communitech, and Murphy filed a lawsuit against Interland, its CEO, Mr. Joel Kocher, and Communitech, in Jackson County, Missouri claiming, among other things, that Interland acted unreasonably in failing to have the S-3 registration statement declared effective by the SEC on a timely basis and claiming that Interland and/or Mr. Kocher made inaccurate disclosures in connection with Interland’s acquisition of Communitech. The complaint asks for compensatory and punitive damages in an unspecified amount. Interland believes that these claims are without merit and will not have a material adverse effect on Interland and intends to vigorously defend the claims.

Interland initiated a lawsuit in the United States District Court for the Northern District of Georgia against the representatives of the former shareholders of Hostcentric (the “Hostcentric Shareholders”), seeking a declaratory judgment that it will be entitled to reimbursement from the escrow fund established as part of the Hostcentric acquisition for any amounts over $180,000 that it may be required to pay to the landlord for a leased facility in Farmingdale, New York. The representatives of the Hostcentric Shareholders have denied Interland’s claims and have attempted to assert various counterclaims. Correspondence between the parties has also discussed the possibility of other claims, but these claims have not yet been asserted in litigation. Interland believes its claims in this case are meritorious, that the counterclaims of the former

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Interland, Inc.
Notes To Consolidated Financial Statements (Continued)

Hostcentric shareholders are without merit, plans to continue to contest the matter vigorously and believes that no material adverse effect on Interland will occur as a result of this litigation.

Interland, through its Hostcentric subsidiary, has also initiated a lawsuit in United States District Court for Southern District of New York against the landlord for the same Farmingdale, New York facility, seeking a declaratory judgment that the lease for that facility has been terminated and that the landlord has accepted that termination, thereby eliminating any further obligation on the part of the tenant to make lease payments. The landlord has denied the claims in the complaint and has asserted counterclaims for approximately $200,000 that it claims is past due under the lease. The landlord may, in the future, assert claims against Interland for the balance of payments due under the Lease which claims, the landlord has asserted, could amount to approximately $2 million in the aggregate. As reported above, Interland believes any obligation found to exist to the landlord in excess of $180,000 is the responsibility of the Hostcentric Shareholders. Interland plans to continue to contest the matter vigorously and believes that no material adverse effect on Interland will occur as a result of this litigation.

Periodically, the Company is made aware that technology it used in its discontinued operations may have infringed on intellectual property rights held by others. The Company has evaluated all such claims and, if necessary and appropriate, sought to obtain licenses for the use of such technology. If the Company or its suppliers were unable to obtain licenses necessary to use intellectual property in its discontinued operation’s products or processes, it may be forced to defend legal actions taken against it relating to allegedly protected technology. The Company evaluates all such claims and has accrued a liability and charged discontinued operations for the estimated costs of settlement or adjudication of claims for alleged infringement as of the respective dates of the balance sheets included in this report. As of May 31, 2004, the Company had an aggregate amount of $1.0 million accrued for such matters.

The Company is also a defendant in a number of other lawsuits that the Company regards as unlikely to result in any material payment; nonetheless, the outcome of litigation may not be assured, and the Company’s cash balances could be materially affected by an adverse judgment. In accordance with SFAS No. 5 “Accounting for Contingencies,” the Company believes it has adequately reserved for the contingencies arising from the above legal matters where an outcome was deemed to be probable and the loss amount could be reasonably estimated. As such, the Company does not believe that the anticipated outcome of the aforementioned proceedings will have a materially adverse impact on its results of operations, its financial condition or its cash flows.

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Interland, Inc.

Item 2. Management’s Discussion And Analysis Of Financial Condition And Results
Of Operations

Statements contained in this Form 10-Q that are not purely historical are forward-looking statements and are being provided in reliance upon the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” and similar expressions identify forward-looking statements. These forward-looking statements include but are not limited to statements regarding Interland’s expectations of its future liquidity needs, its expectations regarding its future operating results including its planned increase in its revenue levels and the actions the Company expects to take in order to maintain its existing customers and expand its operations and customer base. All forward-looking statements are made as of the date hereof and are based on current management expectations and information available to it as of such date. The Company assumes no obligation to update any forward-looking statement. It is important to note that actual results could differ materially from historical results or those contemplated in the forward-looking statements. Forward-looking statements involve a number of risks and uncertainties, and include risks associated with our target markets and risks pertaining to our ability to successfully integrate the operations and personnel of the recent acquisitions. Factors that could cause actual results to differ materially from expected results are identified in “Risk Factors” below, and in the Company’s annual report on Form 10-K for the year ended August 31, 2003 and in the Company’s other filings with the Securities and Exchange Commission. All quarterly references are to the Company’s fiscal periods ended May 31, 2004, or May 31, 2003, unless otherwise indicated. All annual references are also on a fiscal August 31st year-end basis, unless otherwise indicated. All tabular dollar amounts are stated in thousands.

OVERVIEW

Interland is a leader in delivering standardized business-class Web hosting and online solutions to small- and medium-sized businesses, and in helping them to achieve success by providing the knowledge, services and tools to build, manage and promote businesses online. Interland offers a broad range of products and services, including shared and dedicated hosting services, e-commerce, application hosting, Web site development and marketing and optimization tools. The Company is in its third year of a three-year plan designed to create a profitable business through the amalgamation of numerous relatively small, and for the most part, only marginally profitable entrepreneurial companies. The first two years of the plan were focused on acquiring appropriate businesses and then integrating their operations into a small number of efficient data centers.

The current third year of the plan focuses on stabilizing the revenue generated by the acquired lines of business and on laying the foundation for meaningful growth by developing the Company’s “mass market” or “mainstream market” strategy. The customers of the acquired businesses were primarily those who either had sufficient technical abilities to develop a website, or who could persuade or hire someone to develop the website for them. The hosting company merely provided “power, ping and pipe”—the environment and connections to electricity and telecommunications grids that a specialized computer requires to be able to host a website on the Internet. Although individuals with modest personal computer skills can use any one of a number of widely available template-based programs to create a personal or “consumer” website, the Company believes that the owners of small businesses on which they are dependent for their livelihood will not be satisfied with such websites. The Company also believes that even though most owners of small businesses recognize the potential value to their business of having a website, only a small percentage of such owners have been or will be willing to engage a professional web developer given the cost, and the future dependency on the developer even for small future changes.

In order to develop an attractive alternative for business owners, the Company acquired in early 2003 a powerful software tool that enables only modestly trained SME business personnel to build an impressive website with great functionality in a fraction of the time and at a fraction of the cost charged by website development firms. Since the acquisition, the Company has been developing a line of products and services, known as Business Solutions, designed to help mainstream businesses attract and serve customers through websites supplied by Interland designers using its proprietary software. The Company has been testing and marketing products based on the use of the software tools and believes, based on some nine months of experience, that there is a great potential for its mass market products. Based on initial results the Company, in several stages, increased the number of salespeople, web designers and support personnel dedicated to this effort in order to further test the ability of the distribution and provisioning models to perform profitably at increasingly larger scales. The Company was prepared to accept the expected costs of customer acquisition and provisioning so long as performance matched expectations. At the end of February 2004, however, management concluded that despite the fact that many of the assumptions underlying the business plan were being proven, certain aspects of the business were not performing to the standard required to justify

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Item 2. Management’s Discussion And Analysis Of Financial Condition And Results Of Operations

continued high levels of investment. Accordingly, in early March 2004 the Company publicly announced that it would substantially reduce its investment level and concentrate the website and software development teams in Atlanta for greater interaction with the rest of the company. Management continues to believe that adding website creation and promotion applications and services is essential to expanding the addressable market, and the Company will continue to work to perfect its business model, but without attempting to simultaneously scale a direct sales organization.

Moreover, the Company’s research and experience has shown that even those small businesses that have a website require assistance to make their web presence effective in attracting, tracking, and servicing customers. Many of the functions which Interland offers in conjunction with the websites it designs meet this need and can be offered to owners of websites previously designed by others. The Company continues to develop this aspect of the mainstream business, and believes it to be an increasingly important part of its business in the future.

Interland has entered into a marketing arrangement with Advanta, one of the largest providers in the U.S. of credit cards to small businesses, under which Advanta will market Interland’s web hosting solutions to Advanta’s customer base. Interland anticipates that Advanta will begin its marketing efforts during Interland’s fourth fiscal quarter. At the same time the Company is exploring a variety of distribution channels for its mainstream market products, it is endeavoring to stabilize the revenue derived from its acquired businesses. Because all the acquired businesses are subscription businesses that suffer from “churn”, or the regular loss of customers paying monthly fees, the aggregation of a number of such businesses resulted in loss of customers and their associated revenue each month. Since the Company did not wish to continue the long-term support and development of a myriad of products, few resources were devoted to attracting new customers for the legacy acquired product lines. Sales of only the Interland product lines have not, in the aggregate, been sufficient to replace the churn generated by the acquired businesses, resulting in “net” churn. During the third quarter the monthly net churn averaged $83,000, compared to $62,000 during the prior quarter. (Please refer to Risk Factors — “Ours is a recurring-revenue subscriber business and as such the effects of a net loss of monthly recurring revenue are magnified” for further important information on this topic.) Data center performance, customer satisfaction surveys, and call center performance are all believed by management to be good predictors of future churn, and during the third quarter the trends in all of these measures were favorable.

In order to make all of its products as attractive to potential customers as possible, the Company continues to make investments. Among the improvements being made are enhancements to the security and reliability of the Company’s data center and supported networks, rebuilding the web interfaces used by customers to place orders and to control aspects of their websites, and improving customer care management. The Company intends to operate its data centers to a much higher standard of professionalism than had been achieved by any of the acquired web hosting businesses or by any of the Company’s current competitors. The Company also recognizes that it is incurring unnecessary duplicative costs by continuing to maintain discrete hosting platforms for each of its acquired customer bases. The Company is developing a series of platforms and products, which are intended to be attractive both to new customers and to acquired customers who may be expected to move their sites to a newer platform.

The critical challenges faced by the Company are to stabilize the revenue generated by the acquired businesses and to develop channels for distributing its mass market product that are both highly productive and cost efficient, and there can be no assurance that the Company will be successful in meeting these challenges.

DISCONTINUED OPERATIONS

PC Systems

In fiscal 2001 the Company discontinued the operations of its PC Systems business segment, which was accounted for as discontinued operations in accordance with Accounting Principles Board Opinion (APB) No. 30, “Reporting the Results of Operations — Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions.”

During the third quarter and first nine-months of fiscal 2004, the Company recorded $0.5 million and $1.8 million, respectively, of losses on disposal of discontinued operations primarily in connection with litigation related to the PC Systems business. The Company has several pending claims concerning the intellectual property rights of its discontinued operations and is vigorously defending these claims. The Company expects to incur additional losses from discontinued operations due to the costs of defending these claims.

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Item 2. Management’s Discussion And Analysis Of Financial Condition And Results Of Operations

RESULTS OF CONTINUING OPERATIONS

The Company’s consolidated financial information presents the net effect of discontinued operations separate from the results of the Company’s continuing operations.

Comparison of the Quarters and Nine-Months Ended May 31, 2004 And May 31, 2003

The loss from continuing operations decreased $55.1 million to $81.2 million, or 40.4% and $74.3 million to $98.6 million, or 43.0% for the quarter and for the nine-months ended May 31, 2004, respectively, when compared to the same periods of the prior fiscal year. The basic and diluted loss per share decreased $4.34 per share to $ 5.07 per share, or 46.1%, and $6.05 to $ 6.11 per share, or 49.8% for the quarter and for the nine-months ended May 31, 2004, respectively, when compared to the same periods of the prior fiscal year.

Revenues

Total revenues decreased $0.2 million to $25.7 million, or 0.8%, and $0.9 million to $78.4 million, or 1.1%, respectively, for the quarter and for the nine- months ended May 31, 2004 when compared to the same periods of the prior fiscal year.

Hosting revenues decreased $0.6 million to $24.3 million, or 2.4%, and $2.6 million to $74.5 million, or 3.4% for the quarter and for the nine-months ended May 31, 2004, respectively, when compared to the same periods of the prior fiscal year. Hosting revenues for the third quarter and nine months ended May 31, 2004 include $3.1 million and $9.6 million, respectively from the Hostcentric acquisition that occurred in June 2003. Hosting revenues are comprised of shared, dedicated, mainstream market, application hosting services and domain name registrations. The decrease in hosting revenues is primarily attributable to account cancellations, net of new sales and acquisitions. These cancellations may occur as a result of: a) customer action; b) termination by the Company for non-payment; or c) termination by the Company as a result of a decision to no longer provide a particular service. The Company intends to stabilize the revenue of its acquired Web hosting business by focusing on improving customer retention and increasing sales of hosting services.

Shared average monthly revenue per account was $27.07 and $29.60 during the three months ended May 31, 2004 and 2003, respectively. Dedicated average monthly revenue per account was $305.91 and $440.60 during the three months ended May 31, 2004 and 2003, respectively. These ARPU decreases were partially offset by an increase of shared hosting accounts to approximately 181,000 from 171,000 during the three months ended May 31, 2004 and 2003 respectively, and an increase in dedicated servers to approximately 9,800 from approximately 7,000 as of May 31, 2004 and 2003 respectively, due to the recent launch of new products with lower price points.

Other revenues increased $0.4 million to $1.3 million, or 38.9%, and $1.7 million to $3.9 million, or 77.4%, for the quarter and for the nine-months ended May 31, 2004, respectively, when compared to the same period of the prior fiscal year. Other revenues for the third quarter and nine months ended May 31, 2004 include $0.4 million and $1.2 million, respectively from the Hostcentric acquisition that occurred in June 2003. Other revenues are primarily comprised of consulting, co-location, and other fees under contract.

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Item 2. Management’s Discussion And Analysis Of Financial Condition And Results Of Operations

Operating Costs and Expenses

Network Operating Costs

Network operating costs decreased 8.0% to $7.4 million and 20.7% to $21.6 million for the quarter and for the nine-months ended May 31, 2004, respectively, from $8.1 million and $27.2 million in the same periods of the prior year. The Company’s network operating expenses as a percentage of revenues were 28.9% and 27.5% for the quarter and for the nine-months ended May 31, 2004 respectively, as compared to 31.1% and 34.3% in the same periods of the prior fiscal year. The decrease in network operating costs in these periods was primarily related to the data center consolidation, which was a critical part of the Company’s restructuring and integration initiative and was completed in June 2003. This initiative provided a $0.4 million reduction in bandwidth connectivity costs when comparing the quarter ended May 31, 2004 to the same period for the prior year. The Company reached an agreement regarding a domain registration liability in the third quarter of 2003, which resulted in an additional expense of $0.5 million. These decreases were partially offset by an additional $0.7 million in labor related costs due to the company’s commitment to improving customer satisfaction.

Sales and Marketing

Sales and marketing expenses decreased 13.4% to $5.0 million and increased 7.1% to $16.7 million for the quarter and for the nine-months ended May 31, 2004, respectively, from $5.7 million and $15.6 million in the same periods of the prior year. The Company’s sales and marketing expenses as a percentage of revenues was 19.3% and 21.3% for the quarter and for the nine-months ended May 31, 2004, respectively, as compared to 22.1% and 19.7% in the same periods of the prior fiscal year.

The 13.4% quarterly decrease is primarily due to a decrease in outside marketing expenditures of $1.2 million partially offset by an increase in labor related costs of $0.4 million primarily resulting from the expansion of the Company’s mainstream market initiatives earlier in fiscal year 2004. The 7.1% year-to-date increase is primarily due to an increase in labor related costs of $1.6 million. In March 2004, the Company reduced the expenses related to the mainstream marketing initiative that began during the third quarter of fiscal year 2003.

Technical Support

Technical support expenses increased 13.0% to $4.5 million and 21.2% to $14.0 million for the quarter and for the nine-months ended May 31, 2004, respectively, from $4.0 million and $11.5 million in the same periods of the prior year. The Company’s technical support expenses as a percentage of net revenues were 17.6% and 17.8% for the quarter and for the nine-months ended May 31, 2004, respectively, as compared to 15.4% and 14.5% in the same periods of the prior fiscal year. The Company enhanced its technical support efforts to improve customer service resulting in a $0.3 million increase in labor related costs and a $0.2 million increase in related occupancy costs for the quarter ended May 31, 2004 when compared to the same period of the prior year. The comparison of the nine-months ended May 31, 2004 reflects a $1.8 million increase in labor related costs and a $0.8 million increase in related occupancy costs when compared to the same period in the prior year.

General and Administrative

General and administrative expenses decreased 35.8% to $7.7 million and 26.6% to $23.7 million for the quarter and for the nine-months ended May 31, 2004, respectively, from $12.0 million and $32.3 million in the same periods of the prior year. As a percentage of revenues, the Company’s general and administrative expenses was 30.0% and 30.2% for the quarter and for the nine-months ended May 31, 2004, respectively, as compared to 46.4% and 40.7% in the same periods of the prior year. The primary factors causing the quarterly decrease in general and administrative expenses were a $2.1 million decrease in labor related costs associated with the reduction of headcount compared to prior year, a decrease of $0.7 million in legal costs, and a decrease of $0.4 million in related occupancy costs due to the consolidation of office spaces. The decrease in the comparative nine-month periods was primarily due to a $5.3 million decrease in labor related costs, a $1.5 million decrease in professional and technical fees, and a $0.8 million decrease in related occupancy costs.

The Company’s employee base has been reduced from 701 as of May 31, 2003 to 681 as of May 31, 2004.

Bad Debt Expense

Bad debt expense decreased 55.7% to $0.9 million and 49.2% to $2.9 million for the quarter and for the nine-months ended May 31, 2004, respectively, from $2.0 million and $5.8 million in the same periods of the prior year. The decrease in bad debt expense is due to more stringent collection and customer account termination policies.

15

Interland, Inc.
Item 2.  Management’s Discussion And Analysis Of Financial Condition And Results Of Operations

Depreciation and Amortization

Depreciation and amortization expenses decreased 67.0% to $7.3 million and 50.1% to $23.8 million, for the quarter and for the nine-months ended May 31, 2004, respectively, from $22.2 million and $47.6 million in the same periods of the prior year. The Company’s depreciation and amortization expenses as a percentage of revenues was 28.5% and 30.3% for the quarter and for the nine-months ended May 31, 2004, respectively, as compared to 85.7% and 60.0% in the same periods of the prior year. During the third quarter of fiscal 2003, management used the expected discounted present value of future cash flows to determine the fair value of the Company’s identifiable intangible assets and determined that the carrying amount of these assets was higher than their fair values. Upon completion of the assessment, the Company recorded a non-cash impairment charge of $13.9 million to reduce the carrying value of identifiable intangible assets to estimated fair values. As such, the amortization expense of the third quarter of fiscal 2004 was substantially lower than the third quarter of fiscal 2003. Also during the third quarter of fiscal 2003, the Company recorded $9.8 million of accelerated depreciation on the assets associated with closed data centers in Seattle, Los Angeles and Kansas City and $9.6 million additional depreciation and amortization charges associated with acquired entities and purchased assets. With the lower asset base, depreciation expense for the third quarter ended May 31, 2004 was lower than the same period of the prior year.

Restructuring Costs

Restructuring costs were $0.8 million for the quarter and for the nine-months ended May 31, 2004 from $2.2 million and $5.6 million in the same periods of the prior year. The restructuring costs in the third quarter relate to the decision by the Company to change its approach to distributing its mainstream market hosting solutions from reliance upon a direct field sales force to an indirect channel approach. As a result of these restructuring actions the Company is expected to generate approximately $5.2 million of annualized savings.

Merger and Integration Costs

During the Company’s fiscal quarter and for the nine-months ended May 31, 2004 no merger and integration expenses were incurred. During the nine months ended May 31, 2003, the Company recorded $0.5 million for financial advisory services, legal, accounting, relocation, employee stay bonuses and other non-capitalizable expenses directly related to merger and integration of the business following the Interland-Georgia acquisition and other acquisitions occurring in fiscal 2002.

Goodwill Impairment

In accordance with the requirements of SFAS 142, the Company completed its annual goodwill impairment test which entailed comparing the aggregate market value of the company’s outstanding securities plus its liabilities to the aggregate carrying value of the Company’s assets, including goodwill and other indefinite life intangible assets. The Company’s market price of its stock has experienced significant volatility over the last fiscal year and closed as of May 31, 2004, with a market value significantly less that the value at the beginning of the fiscal year. Management retained valuation specialists to assist in the valuation of its tangible and identifiable intangible assets for purposes of determining the implied fair value of goodwill at May 31, 2004. Upon completion of the annual assessment, Interland recorded a non-cash impairment charge of $66.6 million to write-off the remainder of the carrying value of goodwill.

Asset Impairment

During the third quarter of 2004, the Company performed an impairment test pursuant to the guidance provided by SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”. Upon completion of the assessment, Interland recorded a non-cash impairment charge of $4.8 million, reducing the carrying value of certain core technology, customer relationships, trademarks and other intangible assets to their new estimated fair values. The following table summarizes intangible assets by asset class and related accumulated amortization:

The Company had invested in ADC software to improve its customer billing process. The project was delayed during the first quarter of 2004 until further research could be completed and analyzed as to the functionality and benefits of implementing this software. The decision was made in the third quarter of 2004 to abandon the project and record the impairment of the capitalized costs incurred of $2.2 million.

16

Interland, Inc.
Item 2.  Management’s Discussion And Analysis Of Financial Condition And Results Of Operations

Interest Income (Expense), net

Interest income (expense) increased to $0.1 million and decreased to $(0.2) million, respectively, for the quarter and for the nine-months ended May 31, 2004 from $(0.1) and $0.1 million in the same periods of the prior year. Interest income (expense), net consists of interest income earned on the Company’s combined cash and cash equivalents, short-term investments, and restricted investments less interest expense on debt (primarily capital leases). The change is primarily due to the lower levels of cash and liquid investments that were available for investment, lower interest rates and interest expense incurred in the early payoff of an outstanding line of credit.

Net Cash Used in Operating Activities and Earnings from Continuing Operations Before Interest, Taxes, Depreciation and Amortization (EBITDA)

EBITDA is defined as net income (loss) less (i) provision for income taxes, (ii) interest income or expense, and (iii) depreciation and amortization. EBITDA is not an indicator of financial performance under generally accepted accounting principles and may not be comparable to similarly captioned information reported by other companies. In addition, it does not replace net income (loss), operating income (loss), or cash flows from operating activities as indicators of operating performance. The effect of taxes and interest on Interland’s net loss is not significant, but depreciation and amortization, primarily as a result of acquisitions, is significant. The Company believes that measuring the performance of the business without regard to non-cash depreciation and amortization can make trends in operating results more readily apparent, and when considered with other information, assist investors and other users of the Company’s financial statements who wish to evaluate the Company’s ability to generate future cash flows.

The following table reflects the calculation of EBITDA from continuing operations and a reconciliation to net cash provided by (used in) operating activities:

For the quarter ended and for the nine-months ended May 31, 2004, the Company’s EBITDA increased $39.4 million and $50.1 million, respectively, resulting in an EBITDA loss of $74.0 million and $74.6 million. This increase is primarily due to the cost savings from the integration and restructuring efforts during fiscal year 2003 and the decrease in bad debt expense attributed to the more stringent collection and customer account termination policies.

17

Interland, Inc.
Item 2.  Management’s Discussion And Analysis Of Financial Condition And Results Of Operations

Liquidity and Capital Resources

As of May 31, 2004, the Company had $31.0 million in cash and cash equivalents. In addition, the Company had $2.5 million in short-term investments and $11.2 million in short and long-term restricted investments representing a total of $44.7 million of restricted and unrestricted cash and investments. This represents a decrease of $25.5 million compared to August 31, 2003.

Of the $11.2 million in restricted investments, $4.7 million serves as collateral for a financing agreement with U.S. Bancorp Oliver-Allen Technology Leasing. This amount will gradually decrease until the agreement terminates in February 2009. The remainder of the restricted investments relates to collateral amounts for merchant services agreements and does not have a stated maturity date.

On a comparative basis cash used in operating activities of continuing operations decreased $20.5 million or 76.4% to $6.5 million for the nine-months ended May 31, 2004 versus the $26.9 million of cash used in operating activities for the same period in the prior year. The reduction in cash used in continuing operations is reflective of the Company’s integration initiatives that reduced facility, bandwidth connectivity and employee related costs. Cash provided by investing activities decreased $19.5 million or 62.6% to $11.7 million for the nine-months ended May 31, 2004 versus $31.1 million of cash provided by investing activities for the same period in the prior year. The decrease in cash generated from investing activities is primarily related to a reduction in the investments that were liquidated in order to fund daily cash requirements. Cash used in financing activities decreased $11.1 million or 59.0% to $7.7 million for the nine-months ended May 31, 2004 versus the $18.8 million of cash used in financing activities for the same period of prior year. The decrease in cash used in financing activities is primarily due to the reduction of overall debt and capital lease obligations. Cash used in discontinued operations decreased $0.2 million or 10.8% to $1.8 million for the nine-months ended May 31, 2004.

In July 2001, the Company entered into a financing arrangement with U.S. Bancorp Oliver-Allen Technology Leasing for a sale and leaseback of up to $14.6 million for certain equipment, primarily computer hardware. The stated interest rate on the facility is 5.75%. In January 2002, the Company repurchased certain of the leased assets from U.S. Bancorp Oliver-Allen Technology Leasing at a total cost of $2.9 million. In connection with the repurchase, approximately $3.3 million of cash and equivalents became unrestricted. On February 1, 2004, the Company terminated the sale and leaseback agreement and repurchased the assets. In conjunction with this lease termination the company executed a five-year promissory note with US Bancorp Oliver-Allen Technology Leasing for the repurchase amount. As of May 31, 2004, the principal balance on the promissory note was $4.5 million. The Company has pledged $4.7 million as collateral for this promissory note; this amount will gradually decrease until the agreement terminates in February 2009. These restrictions prevent the Company from utilizing the related cash and cash equivalents until all of its obligations under the note are satisfied. The promissory note requires monthly payments of $93,000 over the next five years.

The Company anticipates making capital expenditures of approximately $13.5 million during fiscal 2004, generally for server equipment and related software, hardware to improve service reliability and security, integration and restructuring activities, and other expenditures related to new customer growth. During the first nine-months of fiscal 2004, the Company expended $10.9 million on capital equipment purchases.

The Company’s continued future success is dependent upon its ability to achieve and sustain positive cash flow prior to the depletion of cash resources and to raise funds, thereafter, if needed. The Company assessed its overall cash flow and cash balances for the next four quarters. Although the Company does not believe that it can achieve meaningful positive cash flows during that period (primarily due to payment of accrued liabilities), the Company believes it has adequate cash and liquid resources to fund operations and planned capital expenditures through at least the next 12 months. The Company’s long-term cash needs will be dependent upon additional factors such as pricing pressures, level of investment on data center reliability and security improvement, our ability to reduce net churn and unexpected costs associated with discontinued operations and pending litigations.

Recently Issued Accounting Standards

In January 2003, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46). FIN 46 clarified the application of Accounting Research Bulletin No. 51, Consolidated Financial Statements, to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated support from other parties. FIN 46 requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively

18

Interland, Inc.
Item 2.  Management’s Discussion And Analysis Of Financial Condition And Results Of Operations

disperse risks among parties involved. The Company has evaluated its investments and other relationships and concluded that none meet the requirements for consolidation under FIN 46.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” This statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. This statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective for the first quarter of fiscal year 2004. The adoption of this standard on September 1, 2003 did not have a material impact on Interland’s consolidated financial statements.

RISK FACTORS

You should carefully consider the following factors and all other information contained in this Form 10-Q and the Company’s recently filed Form 10-K for the fiscal year ended August 31, 2003 before you make any investment decisions with respect to the Company’s securities. The risks and uncertainties described below are not the only risks the Company faces.

Interland has incurred losses since inception and could incur losses in the future.

Interland has incurred net losses and losses from operations for all but one of each quarterly period from its inception through the quarter ended May 31, 2004. A number of factors could increase its operating expenses, such as:

     • Adapting network infrastructure and administrative resources to accommodate additional customers and future growth;

     • Developing products, distribution, marketing, and management for the mainstream market;

     • Broadening customer technical support capabilities; and

     • Improving network security features.

In addition, the Company recently has experienced a decline in quarterly revenues. Increases in expenses or further decreases in revenues may cause operating losses to increase.

Ours is a recurring-revenue subscriber business and as such the effects of a net loss of monthly recurring revenue are magnified.

A large majority of our revenue is derived from the monthly recurring charges (“MRC”) incurred by owners of hosted websites. Accordingly, the termination of a single account paying $30.00 per month will affect revenue every month in the future. The loss of such a customer at the beginning of a fiscal year will result in a twelve-fold reduction in revenue for that fiscal year, and the loss of even one such customer each month of the fiscal year will result in a diminution of 78 times the monthly recurring revenue, or $2,340 over the entire fiscal year. Absent the addition of customers through acquisitions, Interland has consistently incurred a net loss in MRC, and this situation may continue with material negative effects on reported revenue and net income. Although reductions in MRC may be offset for a time by increases in revenue derived from one-time or non-recurring charges, the compounding effect of MRC losses will almost certainly eventually result in a meaningful reduction of reported revenue. Moreover, because of Interland’s relatively low percentage of variable costs, a concomitantly high percentage of the amount of revenue loss results in a loss of EBITDA and of net income. There can be no assurance that Interland’s efforts to reduce the loss of MRC will be successful.

Because Interland’s historical financial information is not representative of its future results, investors and analysts will have difficulty analyzing Interland’s future earnings potential.

Because the Company has grown through acquisition and its past operating results reflect the costs of integrating these acquisitions, historical results are not representative of future expected operating results. Furthermore, the Company’s historical annual financial results reflect only the partial impacts of recent acquisitions. In addition, because the Company will be seeking to drive revenue growth primarily through its “mainstream market” initiative, which is a new market for the Company, it will be challenging to predict future revenues. As a result, investors and their advisors will find it challenging to predict future operating income.

Interland has a limited operating history and its business model is still evolving, which makes it difficult to evaluate its prospects.

19

Interland, Inc.
Item 2.  Management’s Discussion And Analysis Of Financial Condition And Results Of Operations

Interland’s limited operating history makes evaluating its business operations and prospects difficult. Its range of service offerings has changed since inception and its business model is still developing. Interland has changed from being primarily a seller of personal computers and related accessories to being primarily a Web hosting and Web based value added business solutions provider to small- and medium-sized businesses company. Because some of its services are new, the market for them is uncertain. As a result, the revenues and income potential of its business, as well as the potential benefits of its acquisitions, may be difficult to evaluate.

Quarterly and annual operating results may fluctuate, which could cause Interland’s stock price to be volatile.

Past operating results have fluctuated significantly on a quarterly and an annual basis. Quarterly and annual operating results may continue to significantly fluctuate due to a wide variety of factors. Because of these fluctuations, comparing operating results from period to period is not necessarily meaningful, and it would not be prudent to rely upon such comparisons as an indicator of future performance. Factors that may cause its operating results to fluctuate include, but are not limited to:

•

Demand for and market acceptance of the Company’s services and products;

•

Introduction of new services or enhancements by Interland or its competitors;

•

Costs of implementing new network security features;

•

Technical difficulties or system downtime affecting the Internet generally or its hosting operations specifically;

•

Customer retention;

•

Increased competition and consolidation within the Web hosting and applications hosting markets;

•

Changes in its pricing policies and the pricing policies of its competitors; and

•

Gains or losses of key strategic partner relationships.

Interland cannot provide any assurances that it will succeed in its plans to increase the size of its customer base, the amount of services it offers, or its revenues during the next fiscal year and beyond. In addition, relatively large portions of its expenses are fixed in the short term, and therefore its results of operations are particularly sensitive to fluctuations in revenues. Also, if it cannot continue using third-party products in its service offerings, its service development costs could increase significantly.

Interland’s stock price may be volatile which could cause an investment in its common stock to decrease significantly.

The market price of Interland common stock has experienced a significant decline. The price has been and is likely to continue to be highly volatile. The following are examples of factors or developments that would likely cause the Company’s stock price to continue to be volatile:

•

Variations in operating results and analyst earnings estimates;

•

The volatility of stock within the sectors within which it conducts business;

•

Announcements by Interland or its competitors regarding introduction of new services;

•

General decline in economic conditions;

•

Reductions in the volume of trading in its common stock and;

•

The Company’s inability to reduce the rate of account cancellations, or to increase the rate of account additions, or both.

During the 52 weeks ended May 31, 2004, the high and low closing price for Interland common stock on NASDAQ was $12.20 and $2.67, respectively.

Interland operates in a new and evolving market with uncertain prospects for growth and may not be able to achieve and sustain growth in its customer base or to maintain its average revenue per customer account (ARPU).

The market for Web hosting and applications hosting services for small- and medium-sized businesses, and especially the mainstream market, has only recently begun to develop and is evolving rapidly. Interland’s future growth, if any, will depend upon the willingness of small- and medium-sized businesses to purchase Web and applications services, Interland’s ability to increase or at least maintain its average revenues-per customer, and its ability to retain customers. As of May 31, 2004, Interland’s average monthly revenue per customer account was $27.07 for shared hosting services and $305.91 for dedicated hosting services, and its average monthly customer turnover was 3.6% for shared hosting services and 5.7% for dedicated hosting services. The corresponding average monthly revenue per customer as of May 31, 2003 was $29.60 for shared hosting services and $440.60 for dedicated hosting services, and the associated average monthly customer turnover rates were 4.0% for shared hosting services and 6.1% for dedicated hosting services. The market for Interland’s services may not develop further, consumers may not widely adopt its services and significant numbers of businesses or organizations may not use the Internet for commerce and communication. If this market fails to develop further or develops more slowly than

20

Interland, Inc.
Item 2.  Management’s Discussion And Analysis Of Financial Condition And Results Of Operations

expected, or if Interland’s services do not achieve broader market acceptance, Interland will not be able to grow its customer base. In addition, Interland must be able to differentiate itself from its competition through its service offerings and brand recognition. These activities may be more expensive than Interland anticipates, and Interland may not succeed in differentiating itself from its competitors, achieving market acceptance of its services, or selling additional services to its existing customer base.

Interland’s ability to significantly organically grow revenue is dependent, in part, on successful penetration of the “mainstream market” of small-and-medium-sized businesses lacking an effective Web presence.

The “mainstream market” of small-and-medium-sized businesses lacking an effective Web presence has only been evaluated with limited market research and trials. In addition, the Company’s potential for success is dependent upon the successful market introduction of the Company’s software-based Web site development product offerings. Delays in seizing this market initiative and/or in the related product introduction could slow or limit the Company’s future revenue growth.

Interland’s “mainstream market” initiative could cause losses for Interland, particularly within the next fiscal year.

The Company has initiated a product line and marketing program directed at the “mainstream market” of SMBs without an effective Web presence. This initiative is described in fuller detail in the “Business” section. This is a new product line, and the products and services in this line may prove unprofitable to the Company unless it is successful in implementing them and achieving economies of scale in its distribution and service delivery activities. Although the Company has announced that it is reducing its level of investment in this initiative, such reduction may only be temporary, and financial results during this period of retrenchment will not necessarily be indicative of future performance if investment is resumed.

Because Interland’s target markets are volatile, the Company may face a loss of customers or a high level of non-collectible accounts.

The Company intends to continue to concentrate on serving the small- and medium-sized business market. This market contains many businesses that may not be successful, and consequently present a substantially greater risk for non-collectible accounts receivable and for non-renewal. Moreover, a significant portion of this target market is highly sensitive to price, and may be lost to a competitor with a lower pricing structure. Because few businesses in this target market employ trained technologists, they tend to generate a high number of customer service and technical support calls. The expense of responding to these calls is considerable, and the expense is likely to increase in direct proportion to revenue, potentially limiting the scalability of the business. Additionally, if the customer becomes dissatisfied with the Company’s response to such calls, cancellation, non-payment, or non-renewal becomes more likely. Interland’s strategy for minimizing the negative aspects of its target market include:

•

Increased expenditures on sales and marketing programs to replace failing customers;

•

Capitalizing on infrastructure efficiencies to become a profitable provider at the lowest sustainable price;

•

Automating customer care and technical support to reduce the cost per call, and to minimize the time spent by Company personnel; and,

•

Intensive training and supervision of customer care and technical support personnel to maximize customer satisfaction.

The Company can give no assurance, however, that any of these measures will be successful, and the Company’s failure to manage these risks could decrease revenues and profitability.

Interland could incur liabilities in the future relating to its PC Systems business, which could cause additional operating losses.

Interland could incur liabilities from the sale of the PC Systems business to GTG PC Holdings, LLC, (“GTG PC”). According to the terms of its agreement with GTG PC, it retained liabilities relating to the operation of the PC systems business prior to the closing of the transaction including liabilities for taxes, contingent liabilities and liabilities for accounts payable accrued prior to the closing. It also agreed to indemnify GTG PC and its affiliates for any breach of its representations and warranties contained in the agreement for a period of two years, or for the applicable statute of limitations for matters related to taxes. Its indemnification obligation is capped at $10.0 million. Except for claims for fraud or injunctive relief, this indemnity is the exclusive remedy for any breach of its representations, warranties and covenants contained in the agreement with GTG PC. Accordingly, it could be required in the future to make payments to GTG PC and its affiliates in accordance with the agreement, which could adversely affect its future results of operations and cash flows. To date it has not had to satisfy any

21

Interland, Inc.
Item 2.  Management’s Discussion And Analysis Of Financial Condition And Results Of Operations

indemnification. For the nine-months ended May 31, 2004, the Company incurred $1.8 million in litigation expenses from the PC business. The Company expects to incur additional expense relating to defending or settling PC related claims.

Unfavorable results of existing litigation may cause Interland to have additional expenses or operating losses.

The Company is a defendant in a number of lawsuits, which the Company regards as unlikely to result in any material payment. See Part II – Item 1 “Legal Proceedings.” Nonetheless, the outcome of litigation may not be assured, and the Company’s cash balances could be materially affected by an adverse judgment.

Because Interland faces intense competition, it may not be able to operate profitably in its markets.

The Web hosting and applications hosting markets are highly competitive, which could hinder Interland’s ability to successfully market its products and services. The Company may not have the resources, expertise or other competitive factors to compete successfully in the future. Because there are few substantial barriers to entry, the Company expects that it will face additional competition from existing competitors and new market entrants in the future. Many of Interland’s current and potential competitors have greater name recognition and more established relationships in the industry and greater resources. As a result, these competitors may be able to:

•

Develop and expand their network infrastructures and service offerings more rapidly;

•

Adapt to new or emerging technologies and changes in customer requirements more quickly; and,

•

Devote greater resources to the marketing and sale of their services and adopt more aggressive pricing policies than the Company can.

Current and potential competitors in the market include Web hosting service providers, applications hosting providers, Internet service providers, telecommunications companies, large information technology firms and computer hardware suppliers. These competitors may operate in one or more of these areas and include companies such as NTT/Verio, Affinity Internet, Earthlink and United Internet.

Impairment of Interland’s intellectual property rights could negatively affect its business or could allow competitors to minimize any advantage that Interland’s proprietary technology may give it.

The Company currently has no patented technology that would preclude or inhibit competitors from entering the Web hosting market that it serves. While it is the Company’s practice to enter into agreements with all employees and with some of its customers and suppliers to prohibit or restrict the disclosure of proprietary information, the Company cannot be sure that these contractual arrangements or the other steps it takes to protect its proprietary rights will prove sufficient to prevent illegal use of its proprietary rights or to deter independent, third-party development of similar proprietary assets.

Effective copyright, trademark, trade secret and patent protection may not be available in every country in which its products and services are offered. Interland currently is, and in the future may be, involved in legal disputes relating to the validity or alleged infringement of its intellectual property rights or those of a third party. Intellectual property litigation is typically extremely costly and can be disruptive to business operations by diverting the attention and energies of management and key technical personnel. In addition, any adverse decisions could subject it to significant liabilities, require it to seek licenses from others, prevent it from using, licensing or selling certain of its products and services, or cause severe disruptions to operations or the markets in which it competes which could decrease profitability.

Periodically, it is made aware of claims, or potential claims, that technology it used in its discontinued operations may have infringed on intellectual property rights held by others. The Company has accrued a liability and charged operations for the estimated costs of settlement or adjudication of several asserted and unasserted claims for alleged infringement relating to its discontinued operations prior to the balance sheet date. Resolution of these claims could be costly and decrease profitability.

If Interland is unable to attract and retain key personnel, it may not be able to compete effectively in its market.

The future success of Interland will depend, in part, on its ability to attract and retain key management, technical, and sales and marketing personnel. The Company attempts to enhance its management and technical expertise by recruiting qualified individuals who possess desired skills and experience in certain targeted areas. The Company experiences strong competition for such personnel in the Web hosting industry. The Company’s inability to retain employees and attract and retain sufficient additional employees, information technology, engineering, and technical support resources could adversely affect its ability to remain competitive in its markets. The Company has and may continue to face the loss of key personnel, which could limit the ability of the Company to develop and market its products and services.

22

Interland, Inc.
Item 2.  Management’s Discussion And Analysis Of Financial Condition And Results Of Operations

Interland depends on its reseller sales channel to market and sell many of its services. Interland does not control its resellers, and if it fails to develop or maintain good relations with resellers, it may not achieve the growth in customers and revenues that it expects.

An element of the strategy for the Company’s growth is to further develop the use of third parties that resell its services. Many of these resellers are Web development or Web consulting companies that also sell Interland’s Web hosting services, but that generally do not have established customer bases to which they can market these services. The Company is not currently dependent on any one reseller to generate a significant level of business, but it has benefited and continues to significantly benefit from business generated by the reseller channel. Although Interland attempts to provide its resellers with incentives such as price discounts on its services that the resellers seek to resell at a profit, the failure of its services to be commercially accepted in some markets, whether as a result of a reseller’s performance or otherwise, could cause its current resellers to discontinue their relationships with the Company. The Company is in discussions with Verizon regarding a potential renewal, modification or extension of its current agreement, which otherwise expires November 1, 2004. However, the Company cannot predict the outcome of these discussions. Verizon accounts for 2.8% of the Company’s monthly revenue.

We May Require Additional Cash in the Future and May Not Be Able to Secure Adequate Funds on a Timely Basis or on Terms Acceptable to Us.

We expect to meet our cash requirements over the next 12 months with existing cash, cash equivalents, short-term investments and cash flows from sales of our services and existing credit facilities. If, however, our cash requirements vary materially from those currently planned, or if we fail to generate sufficient cash flow from the sales of our services, management believes it has the ability to curtail capital spending and reduce expenses to ensure our cash and investments will be sufficient to meet our cash requirements for the next 12 months. We may, however, require additional financing sooner than anticipated. In that event, we might not be able to obtain equity or debt financing on acceptable terms, if at all. Also, future borrowing instruments, such as credit facilities and lease agreements, will likely contain covenants which may restrict our ability to incur further indebtedness, and which will likely require us to pledge assets as security for any such borrowings.

Interland is vulnerable to system failures, which could harm its reputation, cause its customers to seek reimbursement for services, and cause its customers to seek another provider for services.

The Company must be able to operate the systems that manage its network around the clock without interruption. Its operations will depend upon its ability to protect its network infrastructure, equipment and customer files against damage from human error, fire, earthquakes, hurricanes, floods, power loss, telecommunications failures, sabotage, intentional acts of vandalism and similar events. Although the Company has attempted to build redundancy into its networks, its networks are currently subject to various points of failure. For example, a problem with one of its routers (devices that move information from one computer network to another) or switches could cause an interruption in the services the Company provides to a portion of its customers. In the past, the Company has experienced periodic interruptions in service. The Company has also experienced, and in the future it may continue to experience, delays or interruptions in service as a result of the accidental or intentional actions of Internet users, current and former employees, or others. Any future interruptions could:

•

Cause customers or end users to seek damages for losses incurred;

•

Require the Company to replace existing equipment or add redundant facilities;

•

Damage the Company’s reputation for reliable service;

•

Cause existing customers to cancel their contracts; or

•

Make it more difficult for the Company to attract new customers.

Interland’s data centers and network vulnerability to security breaches could cause disruptions in its service, liability to third parties, or loss of customers.

A significant barrier to electronic commerce and communications is the need for secure transmission of confidential information over public networks. Some of the Company’s services rely on security technology licensed from third parties that provides the encryption and authentication necessary to effect the secure transmission of confidential information. Despite the design and implementation of a variety of network security measures by the Company, unauthorized access, computer viruses, accidental or intentional actions and other disruptions could occur. In addition, inappropriate use of the network by third parties could also potentially jeopardize the security of confidential information, such as credit card and bank account numbers stored in the Company’s computer systems. These security problems could result in the Company’s liability and could also cause the loss of existing customers and potential customers.

Although the Company continues to implement industry-standard security measures, third parties may be able to overcome any measures that it implements. The costs required to eliminate computer viruses and alleviate other security problems could be prohibitively expensive and the efforts to address such problems could result in interruptions, delays or cessation of service to customers, and harm the Company’s reputation and growth. Concerns over the security of Internet transactions and the privacy of users may also inhibit the growth of the Internet, especially as a means of conducting commercial transactions.

Disruption of Interland’s services caused by unknown software or hardware defects could harm its business and reputation.

The Company’s service offerings depend on complex software and hardware, including proprietary software tools and software licensed from third parties. Complex software and hardware may contain defects, particularly when first introduced or when new versions are released. The Company may not discover software or hardware defects that affect its new or current

23

Interland, Inc.
Item 2.  Management’s Discussion And Analysis Of Financial Condition And Results Of Operations

services or enhancements until after they are deployed. Although Interland has not experienced any material software or hardware defects to date, it is possible that defects may exist or occur in the future. These defects could cause service interruptions, which could damage its reputation or increase its service costs, cause it to lose revenue, delay market acceptance or divert its development resources.

Providing services to customers with critical Web sites and Web-based applications could potentially expose Interland to lawsuits for customers’ lost profits or other damages.

Because the Company’s Web hosting and applications hosting services are critical to many of its customers’ businesses, any significant interruption in those services could result in lost profits or other indirect or consequential damages to its customers as well as negative publicity and additional expenditures for it to correct the problem. Although the standard terms and conditions of the Company’s customer contracts disclaim liability for any such damages, a customer could still bring a lawsuit against it claiming lost profits or other consequential damages as the result of a service interruption or other Web site or application problems that the customer may ascribe to it. A court might not enforce any limitations on its liability, and the outcome of any lawsuit would depend on the specific facts of the case and legal and policy considerations even if the Company believes it would have meritorious defenses to any such claims. In such cases, it could be liable for substantial damage awards. Such damage awards might exceed its liability insurance by unknown but significant amounts, which would seriously harm its business.

Interland could face liability for information distributed through its network.

The law relating to the liability of online services companies for information carried on or distributed through their networks is currently unsettled. Online services companies could be subject to claims under both United States and foreign law for defamation, negligence, copyright or trademark infringement, violation of securities laws or other theories based on the nature and content of the materials distributed through their networks. Several private lawsuits seeking to impose such liability upon other entities are currently pending against other companies. In addition, organizations and individuals have sent unsolicited commercial e-mails from servers hosted by service providers to massive numbers of people, typically to advertise products or services. This practice, known as “spamming,” can lead to complaints against service providers that enable such activities, particularly where recipients view the materials received as offensive. The Company may, in the future, receive letters from recipients of information transmitted by its customers objecting to such transmission. Although the Company prohibits its customers by contract from spamming, it cannot provide assurances that its customers will not engage in this practice, which could subject it to claims for damages.

In addition, the Company may become subject to proposed legislation that would impose liability for or prohibit the transmission over the Internet of some types of information. Other countries may also enact legislation or take action that could impose liability on the Company or cause it not to be able to operate in those countries. On December 16, 2003 the President signed into law the Can SPAM Act of 2003 to prohibit Internet users from sending unsolicited commercial e-mail. Pub. Law. No. 108-187 (the “Can SPAM Act”). The Can SPAM Act prohibits Internet users from collecting or harvesting e-mail addresses using electronic means, prohibits Internet marketers from sending unsolicited commercial e-mails and requires the Federal Trade Commission to conduct a study into the advisability of creating a federal “do not e-mail registry” along the lines of the current “do not call” registry that relates to telemarketing. Interland requires all of its customers to comply with all applicable laws, including the Can SPAM Act. Although to date the Can SPAM Act has not had a significant impact on the Company, there can be no assurance that compliance with the Can SPAM Act will not cause the Company’s operating expenses to increase. The Company does not anticipate that the Can SPAM Act will have a significant impact on the conduct of its business.

The imposition upon the Company and other online services of potential liability for information carried on or distributed through its systems could require it to implement measures to reduce its exposure to this liability, which may require it to expend substantial resources, or to discontinue service offerings. The increased attention focused upon liability issues as a result of these lawsuits and legislative proposals also could affect the rate of growth of Internet use.

Interland’s business operates in an uncertain legal environment where future government regulation and lawsuits could restrict Interland’s business or cause unexpected losses.

Due to the increasing popularity and use of the Internet, laws and regulations with respect to the Internet may be adopted at federal, state and local levels, covering issues such as user privacy, freedom of expression, pricing, characteristics and quality of products and services, taxation, advertising, intellectual property rights, information security and the convergence of traditional telecommunications services with Internet communications. The Company cannot fully predict the nature of future

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Interland, Inc.
Item 2.  Management’s Discussion And Analysis Of Financial Condition And Results Of Operations

legislation and the manner in which government authorities may interpret and enforce such legislation. As a result, Interland and its customers could be subject to potential liability under future legislation, which in turn could have a material adverse effect on the Company’s business. The adoption of any such laws or regulations might decrease the growth of the Internet which in turn could decrease the demand for the Company’s services, or increase the cost of doing business. In addition, applicability to the Internet of existing laws governing issues such as property ownership, copyright and other intellectual property issues, taxation, libel, obscenity and personal privacy is uncertain. These laws generally pre-date the advent of the Internet and related technologies and, as a result, do not consider or address the unique issues of the Internet and related technologies.

Substantial future sales of shares by shareholders could negatively affect Interland’s stock price.

If the Company’s shareholders sell substantial amounts of its common stock in the public market, the market price of its common stock could decline. Only a small portion of the Company’s issued and outstanding shares is subject to any restriction on resale.

Interland operates a large number of acquired platforms in its data center, some of which are less than optimal, and securing, improving, or migrating from these platforms could adversely affect Interland’s earnings and cash flows.

Because the Company has grown by acquisition it continues to serve customers that are supported by legacy hosting platforms. Some of these platforms have experienced, or are approaching, technical obsolescence, and are difficult or expensive to maintain, secure, or upgrade. If the Company continues to support these platforms it will face risks of service failure or customer cancellation. If the Company attempts to migrate the customers supported by these legacy platforms it risks temporary disruption of the customer’s service that may result in customer cancellation. The Company may offer incentives for such a migration, which would temporarily or permanently reduce the revenue derived from customers who accept the incentives.

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Interland, Inc.

Item 3. Quantitative And Qualitative Disclosures About Market Risk

Substantially all of the Company’s liquid investments and a majority of its debt are at fixed interest rates, and therefore the fair value of these instruments is affected by changes in market interest rates. As of May 31, 2004, approximately 93.6% of the Company’s liquid investments mature within three months and 100% mature within one year. As of May 31, 2004, management believes the reported amounts of liquid investments and debt to be reasonable approximations of their fair values. Generally, the fair market value of fixed interest rate investment securities will increase as interest rates fall and decrease as interest rates rise. The Company does not use derivative financial instruments in its investment portfolio. The portfolio has been primarily comprised of commercial paper rated A1/P1, bank certificates rated AA or better, and corporate medium-term notes rated AA or better. At May 31, 2004, the Company’s investment portfolio included fixed rate securities with an estimated fair value of $37.2 million. The interest rate changes affect the fair market values but do not impact earnings or cash flows. The fair market value of long-term fixed interest rate debt is also subject to interest rate risk. Generally, the fair market of fixed interest rate debt will increase as interest rates fall and decrease as interest rates rise. The estimated fair value of the Company’s long-term debt, exclusive of current maturities, at May 31, 2004 was $3.7 million.

Item 4. Controls and Procedures

The Company’s management, including its chief executive officer, chief financial officer and chief accounting officer evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in the Securities Exchange Act of 1934 Rules 13(a) – 14(c), and 14(d)) as of May 31, 2004. Based on this review, the chief executive officer, chief financial officer and chief accounting officer concluded that Interland’s disclosure controls and procedures were effective to provide reasonable assurances that such disclosure controls and procedures satisfy their objectives and that the information required to be disclosed by the Company in its periodic reports is accumulated and communicated to management, including its chief executive officer, chief financial officer and chief accounting officer, as appropriate to allow timely decisions regarding disclosure and is recorded, processed, summarized and reported within the time periods specified in the U.S. Securities and Exchange Commission’s rules and forms.

Nevertheless, the Company’s management, including its chief executive officer, chief financial officer and chief accounting officer, do not expect that the Company’s disclosure controls and procedures will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdown can occur because of simple error or mistake. In particular, many of the Company’s current processes rely upon manual reviews and processes to ensure that neither human error nor system weakness has resulted in erroneous reporting of financial data.

As discussed in prior quarters, the Company has implemented a number of significant improvements to its internal controls over financial reporting. While we continued to make incremental improvements to our internal controls over financial reporting during the quarter ended May 31, 2004, there were no changes in the Company’s internal control over financial reporting which management considered to be material, although any improvement necessarily has the potential to avoid a material misstatement.

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Interland, Inc.

PART II. – OTHER INFORMATION

Item 1. Legal Proceedings

In February 2003, the Company filed a lawsuit in Cobb County, Georgia against Mr. Gabriel Murphy, one of the former principals of Interland’s subsidiary, CommuniTech.Net, Inc. (“Communitech”), which was acquired by Interland in February 2002. The Company’s lawsuit claims, among other things, that Mr. Murphy breached certain covenants under his employment agreement and also demands payment from Mr. Murphy’s two promissory notes (one of which was “non-recourse” while the other was “recourse”). In March 2004, Interland retired the 273,526 shares of stock held as collateral and wrote off the $2,000,000 non-recourse promissory note. The other $735,000 full recourse promissory note remains outstanding and continues to be a subject of the Cobb County litigation noted above.

In February 2003 Messrs. Heitman, also a former principal of Communitech, and Murphy filed a lawsuit against Interland, its CEO, Mr. Joel Kocher, and Communitech, in Jackson County, Missouri claiming, among other things, that Interland acted unreasonably in failing to have the S-3 registration statement declared effective by the SEC on a timely basis and claiming that Interland and/or Mr. Kocher made inaccurate disclosures in connection with Interland’s acquisition of Communitech. The complaint asks for compensatory and punitive damages in an unspecified amount. Interland believes that these claims are without merit and will not have a material adverse effect on Interland and intends to vigorously defend the claims.

Interland initiated a lawsuit in the United States District Court for the Northern District of Georgia against the representatives of the former shareholders of Hostcentric (the “Hostcentric Shareholders”), seeking a declaratory judgment that it will be entitled to reimbursement from the escrow fund established as part of the Hostcentric acquisition for any amounts over $180,000 that it may be required to pay to the landlord for a leased facility in Farmingdale, New York. The representatives of the Hostcentric Shareholders have denied Interland’s claims and have attempted to assert various counterclaims. Correspondence between the parties has also discussed the possibility of other claims, but these claims have not yet been asserted in litigation. Interland believes its claims in this case are meritorious, that the counterclaims of the former Hostcentric shareholders are without merit, plans to continue to contest the matter vigorously, and believes that no material adverse effect on Interland will occur as a result of this litigation.

Interland, through its Hostcentric subsidiary, has also initiated a lawsuit in United States District Court for Southern District of New York against the landlord for the same Farmingdale, New York facility, seeking a declaratory judgment that the lease for that facility has been terminated and that the landlord has accepted that termination, thereby eliminating any further obligation on the part of the tenant to make lease payments. The landlord has denied the claims in the complaint and has asserted counterclaims for approximately $200,000 that it claims is past due under the lease. The landlord may, in the future, assert claims against Interland for the balance of payments due under the Lease which claims, the landlord has asserted, could amount to approximately $2 million in the aggregate. As reported above, Interland believes any obligation found to exist to the landlord in excess of $180,000 is the responsibility of the Hostcentric Shareholders. Interland plans to continue to contest the matter vigorously and believes that no material adverse effect on Interland will occur as a result of this litigation.

Periodically, the Company is made aware that technology it used in its discontinued operations may have infringed on intellectual property rights held by others. The Company has evaluated all such claims and, if necessary and appropriate, sought to obtain licenses for the use of such technology. If the Company or its suppliers were unable to obtain licenses necessary to use intellectual property in its discontinued operation’s products or processes, it may be forced to defend legal actions taken against it relating to allegedly protected technology. The Company evaluates all such claims and has accrued a liability and charged discontinued operations for the estimated costs of settlement or adjudication of claims for alleged infringement as of the respective dates of the balance sheets included in this report. As of May 31, 2004, the Company had an aggregate amount of $1.0 million accrued for such matters.

The Company is also a defendant in a number of other lawsuits that the Company regards as unlikely to result in any material payment; nonetheless, the outcome of litigation may not be assured, and the Company’s cash balances could be materially affected by an adverse judgment. In accordance with SFAS No. 5 “Accounting for Contingencies,” the Company believes it has adequately reserved for the contingencies arising from the above legal matters where an outcome was deemed to be probable and the loss amount could be reasonably estimated. As such, the Company does not believe that the anticipated outcome of the aforementioned proceedings will have a materially adverse impact on its results of operations, its financial condition or its cash flows.

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Interland, Inc.

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

In March 2004, the Company executed on 273,526 shares of stock, at an average price per share of $7.31, held as collateral on a promissory note and immediately retired them from circulation.

ISSUER PURCHASES OF EQUITY SECURITIES

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Item 6.  Exhibits And Reports On Form 8-K

(A)      Exhibits:

(B)      Reports on Form 8-K.

		On April 14, 2004, the Company filed a Form 8-K regarding its financial results for the fiscal quarter ended February 29, 2004.
		On April 19, 2004, the Company filed a Form 8-K with a transcript and related material from its earnings conference call.
		On April 28, 2004, the Company filed a Form 8-K with its amended Code of Conduct.

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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.

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