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EvolvUse these links to rapidly review the document OVERSTOCK.COM, INC. ANNUAL REPORT ON FORM 10-K INDEX INDEX TO CONSOLIDATED FINANCIAL STATEMENTSUNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549FORM 10-K(Mark One) ýANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934For the fiscal year ended December 31, 2004ORoTRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGEACT OF 1934For the transition period from to Commission file number 000-49799OVERSTOCK.COM, INC.(Exact name of Registrant as specified in its charter)Delaware(State or other jurisdiction ofincorporation or organization) 87-0634302(I.R.S. EmployerIdentification Number)6322 South 3000 East, Suite 100Salt Lake City, Utah 84121(Address of principal executive offices including zip code)(801) 947-3100(Registrant's telephone number, including area code)Securities registered pursuant to Section 12(b) of the Act: NoneSecurities registered pursuant to Section 12(g) of the Act:Common Stock, $0.0001 par value (title of class) 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 ExchangeAct of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days. Yes ý No o Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not becontained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K, or any amendment to this Form 10-K. o Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes ý No o The aggregate market value of voting and non-voting common equity held by non-affiliates of the registrant as of the last business day of theregistrant's most recently completed second quarter (June 30, 2004), was approximately $713.8 million based upon the last sales price reported forsuch date on The NASDAQ National Market System. For purposes of this disclosure, shares of Common Stock held by persons who hold morethan 5% of the outstanding shares of Common Stock and shares held by officers and directors of the registrant have been excluded in that suchpersons may be deemed to be affiliates. This determination is not necessarily conclusive. As of March 11, 2005 there were 19,885,188 shares of the registrant's Common Stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE Certain information required by Part III of Form 10-K is incorporated by reference to the Registrant's proxy statement for the 2005 Annual Stockholders Meeting, which will be filed with the Securities and Exchange Commission. OVERSTOCK.COM, INC.ANNUAL REPORT ON FORM 10-KINDEX Part I. Special Note Regarding Forward-Looking StatementsItem 1. BusinessItem 2. PropertiesItem 3. Legal ProceedingsItem 4. Submission of Matters to a Vote of Security Holders Part II.Item 5. Market for the Registrant's Common Equity, Related Stockholder Matters and IssuerPurchases of Equity SecuritiesItem 6. Selected Financial DataItem 7. Management's Discussion and Analysis of Financial Condition and Results of OperationItem 7A. Quantitative and Qualitative Disclosures About Market RiskItem 8. Financial Statements and Supplementary DataItem 9. Changes in and Disagreements with Accountants on Accounting and Financial DisclosureItem 9A. Controls and ProceduresItem 9B. Other Information Part III.Item 10. Directors and Executive Officers of the RegistrantItem 11. Executive CompensationItem 12. Security Ownership of Certain Beneficial Owners and ManagementItem 13. Certain Relationships and Related TransactionsItem 14. Principal Accounting Fees and Services Part IV.Item 15. Exhibits, Financial Statement SchedulesSignaturesFinancial Statements Overstock.com is a registered trademark, and Worldstock.com, Club O and Club O Gold are trademarks, of Overstock.com, Inc. TheOverstock.com logo and Worldstock.com logo are also trademarks of Overstock.com, Inc. Other service marks, trademarks and trade namesreferred to in this Form 10-K are property of their respective owners.ii PART ISPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS This Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of theSecurities Exchange Act of 1934. These statements are therefore entitled to the protection of the safe harbor provisions of these laws. Theseforward-looking statements involve risks and uncertainties, and relate to future events or our future financial or operating performance. Thesestatements include, but are not limited to, statements concerning:•the anticipated benefits and risks of our business relationships; •our ability to attract retail and business customers; •the anticipated benefits and risks associated with our business strategy; •our future operating results; •the anticipated size or trends of the market segments in which we compete and the anticipated competition in those markets; •potential government regulation; •our future capital requirements and our ability to satisfy our capital needs; •our expansion in international markets; •the potential for additional issuances of our securities; •our plans to devote substantial resources to our sales and marketing teams; •the possibility of future acquisitions of businesses, products or technologies; •our belief that we can attract customers in a cost-efficient manner; •our strategy to develop strategic business relationships with additional wholesalers and distributors; •our belief that current or future litigation will likely not have a material adverse effect on our business; •our belief that certain of our stockholders are unlikely to exercise any rights of rescission or certain other remedies that they maypossess; •the anticipated anti-takeover effects of certain provisions of our charter documents; •the ability of our online marketing campaigns to be a cost-effective method of attracting customers; •possible technological improvements to existing inventory management systems, distribution and order fulfillment, networkinfrastructure and website features; •our belief that manufacturers will recognize us as an efficient liquidation solution; •our belief that the national television and radio branding campaign we began during 2003 and continued during 2004 will be effectiveand that the results of the campaign will justify its expense; •our belief that the efforts we have made to improve the search function capabilities of our Websites will be effective and that we willbe able to further improve those capabilities;1 •our belief that the increases we have made in the scope of our Books, Music and Video department offerings will be attractive tocustomers and will result in increased sales of higher margin products; •our belief that we can meet our published product shipping standards even during periods of relatively high sales activity; •our belief that we can maintain or improve upon customer service levels that we and our customers consider acceptable; •our belief that our information technology infrastructure can and will support our operations and will not suffer significant downtime; •our belief that the actions we have taken to improve the efficiency of our warehouse and to decrease our costs of providing customerservice will be effective and will not have adverse effects on our business; •our belief that we can maintain inventory levels at appropriate levels despite the seasonal nature of our business; and •our belief that we can successfully offer and sell a constantly changing mix of products and services, including our recentlyintroduced auctions listing services, our recent addition of limited travel services, and our recent addition of custom-made jewelryproducts. Furthermore, in some cases, you can identify forward-looking statements by terminology such as may, will, could, should, expect, plan,intend, anticipate, believe, estimate, predict, potential or continue, the negative of such terms or other comparable terminology. These statementsare only predictions. Actual events or results may differ materially. In evaluating these statements, you should specifically consider the risksoutlined in this Form 10-K, including those described in Item 1 under the caption "Risk Factors." These factors may cause our actual results todiffer materially from those contemplated by any forward-looking statement. Except as otherwise required by law, we expressly disclaim anyobligation to release publicly any update or revisions to any forward-looking statements to reflect any changes in our expectations or any change inevents, conditions or circumstances on which any of our forward-looking statements are based. Although we believe that the expectationsreflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. ITEM 1. BUSINESS The following description of our business contains forward-looking statements relating to future events or our future financial or operatingperformance that involve risks and uncertainties, as set forth above under "Special Note Regarding Forward-Looking Statements." Our actualresults could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forthunder the heading "Risk Factors" and elsewhere in this Form 10-K.Overview We are an online "closeout" retailer offering discount, brand-name merchandise for sale primarily over the Internet. Our merchandise offeringsinclude bed-and-bath goods, home décor, furniture, kitchenware, watches, jewelry, computers and electronics, sporting goods and apparel anddesigner accessories. We also sell books, magazines, CDs, DVDs, videocassettes and video games ("BMV"). Our company, based in Salt LakeCity, Utah, was founded in 1997, and we launched our first Website through which customers could purchase products in March 1999. OurWebsites offer our customers an opportunity to shop for bargains conveniently, while offering our suppliers an alternative inventory liquidationdistribution channel. We also offer limited travel services. We continually add new, limited2 inventory products to our Websites in order to create an atmosphere that encourages customers to visit frequently and purchase products beforeour inventory sells out. We offer approximately 50,000 non-BMV products and approximately 500,000 BMV products in eight departments on ourmain Website, www.overstock.com. Closeout merchandise is typically available in inconsistent quantities and prices and often is only available to consumers after it has beenpurchased and resold by disparate liquidation wholesalers. We believe that the traditional liquidation market is therefore characterized byfragmented supply and fragmented demand. Overstock utilizes the Internet to aggregate both supply and demand and create a more efficientmarket for liquidation merchandise. We provide consumers and businesses with quick and convenient access to high-quality, brand-namemerchandise at discount prices. We have a "direct" business, in which we buy and take possession of excess inventory for resale. We also have our "fulfillment partner"business (which we formerly called our "commission" business) in which we sell merchandise of other retailers, cataloguers or manufacturers("fulfillment partners") through our Websites. We currently have fulfillment partner relationships with approximately 380 third parties which postapproximately 40,000 non-BMV products, as well as most of the BMV products and all of our current travel offerings, on our Websites. In addition, in September 2004, we launched an online auction site—an online marketplace for the buying and selling of goods—as part of ourWebsite, with multiple product categories. Our auction site is strictly a consumer-to-consumer site; we do not list or sell any goods on this site.During the fourth quarter of 2003, we added a discount travel store to our Website. In May 2004, we closed our travel store in order to makeimprovements to the travel product offerings. In January 2005, we re-opened the travel store on our Website with cruise offerings, and we plan tooffer additional travel services later this year. Our objective is to provide a one-stop destination for discount shopping, whether it is for products orservices, in businesses proven to be successful on the Internet.Industry Overview Manufacturers and retailers traditionally hold inventory to buffer against uncertain demand within their normal, "inline" sales channels. Inlinesales channels are manufacturers' primary distribution channels, which are characterized by regularly placed orders by established retailers at ornear wholesale prices. In recent years, several dynamics have shifted inventory risk from retailers to manufacturers, including:•dominant retailers insist on just-in-time deliveries from manufacturers; •dominant retailers often cancel orders mid-production and return unsold merchandise; •style, color or model changes can quickly turn inventory into closeout merchandise; •incorrect estimates of consumer demand which can lead to overproduction; and •changes in a retailer's financial situation or strategy results in cancelled orders. The disposal of excess, or overstock, inventory represents a substantial burden for many manufacturers, especially those who produce high-quality branded merchandise. Manufacturers seek to avoid liquidating through traditional retail channels where the manufacturer's discountedproducts may be sold alongside other full-price products. This can result in weaker pricing and decreased brand strength, and is known as channelconflict or sales channel pollution. As a result, many manufacturers turn to liquidation wholesalers and discount retailers. These liquidationchannels provide manufacturers limited control of distribution and are, we believe, unreliable and expensive to manage when compared with theirinline channels.3 Despite the challenges encountered by manufacturers in the liquidation market, the proliferation of outlet malls, wholesale clubs and discountchains is evidence of the strong level of consumer demand for discount and closeout merchandise. However, consumers face several difficultiesin shopping for closeout and overstock merchandise. For example, many traditional merchandise liquidation outlets are located in remote locationsand have limited shopping hours, which we believe makes shopping burdensome and infrequent for many consumers. In addition, the spaceavailable in a traditional merchandise liquidation outlet constrains the number of products that a traditional merchandise liquidation outlet can offerat any given time. However, we believe that the market for online liquidation is still early in its development and is characterized by only a limited number ofcompetitors, some of which utilize an auction model to price their goods. Furthermore, we believe that there are no dominant companies in theonline liquidation market, and many of the companies that do offer overstock or liquidation merchandise are focused on single product lines. Lastly, small retailers are under competitive pressure from large national retailers. Small retailers generally do not have purchasing leveragewith manufacturers; consequently, they are more likely to pay full wholesale prices and are more likely to receive inferior service. We believe thatsmall retailers generally do not have access to the liquidation market because liquidation wholesalers are most often interested in liquidating largevolumes of merchandise, rather than the small quantities appropriate for small, local retailers.The Overstock Solution Overstock utilizes the Internet to create a more efficient market for liquidation merchandise. We provide consumers and businesses withquick and convenient access to high-quality, brand-name merchandise at discount prices. As previously mentioned, we have both a "direct" business and a "fulfillment partner" business. We currently have fulfillment partnerrelationships with approximately 380 third parties which post approximately 40,000 non-BMV products, as well as most of the BMV products andall of our current travel offerings, on our Websites. For both our direct and our fulfillment partner businesses we have a consumer ("B2C") and abusiness-to-business ("B2B") sales channel. Although we have historically operated a separate B2B Website, our direct revenue haspredominantly been based on purchases made directly through our consumer Website. As a result, during the third quarter of 2004, we integratedthe B2B Website into our consumer Website. B2B clients now buy products primarily through our Club O frequent buyers club and our Club O Goldbulk purchase program. During 2004, no single customer accounted for more than 1% of our total revenue. During September 2004, we added an online auction service to our Website. Our auction service allows sellers to list items for sale, buyersto bid on items of interest, and users to browse through listed items online. We are not the seller of the items sold on the auction site and we haveno control over the pricing of those items. Therefore, for auctions, we record only our listing fees for items listed and commissions for items soldas revenue. For the year ended December 31, 2004, our auction revenues were insignificant. During the first quarter of 2005, we reopened our discount travel store on our Website offering cruise packages. In the future, we intend tooffer other travel products such as flight, hotel, and rental car reservations. For the products or services that we sell in our travel store, we do notcurrently have inventory risk or pricing control, and do not directly provide customer service. Therefore, for these sales we are not considered to bethe primary obligor, and record only our commission as revenue. During the year ended December 31, 2004, we fulfilled approximately 40% of all orders through our leased Salt Lake City, Utah warehouse orour outsourced warehouse located in Plainfield, Indiana.4 Our warehouses generally ship between 10,000 and 12,000 orders per day, and up to approximately 24,000 orders per day during peak periods,using overlapping daily shifts. The balance of our orders (approximately 60%) was for inventory owned and shipped by our third-party fulfillmentpartners. Prior to July 1, 2003, we did not physically handle the merchandise we sold for our fulfillment partners, as the merchandise was shippeddirectly by them. They also handled all customer returns related to those sales. Beginning July 1, 2003, we took responsibility for returned itemsrelating to these sales and we now handle the possible resale of returned items. We made the decision to change this policy to have more controlover the Overstock customer shopping experience, as we believe that a seamless customer experience is key to creating loyal, long-termcustomers. By accepting returns at our warehouse, we can verify that fulfillment partner products are being packaged and shipped to ourstandards. Additionally, as customer returns are now all shipped to one location, the process is more convenient for our customers. As a result,beginning July 1, 2003, we are considered to be the primary obligor for these sales transactions, and we assume the risk of loss on returned items.As a consequence, we now record revenue from sales transactions involving our fulfillment partners (excluding auction and travel products) on agross basis, rather than on a net basis as we did prior to July 1, 2003. Overstock provides manufacturers with a one-stop liquidation channel to sell both large and small quantities of excess and closeoutinventory without disrupting sales through traditional channels. Key advantages for manufacturers liquidating their excess inventory throughOverstock include:•Resolution of channel conflict. Channel conflicts arise when a manufacturer's excess inventory is sold through the same channel astheir other product offerings. Since excess inventory is usually sold at a discount, sales of the manufacturer's other product offeringsmay be impacted as a consumer in a retail store may opt for the excess product or become confused by the pricing and modeldiscrepancies. By using Overstock, manufacturers have an alternative and independent channel where they can sell excessinventory without the fear of hindering the sale of their other products. •Single point of distribution. Manufacturers often use multiple liquidation sources to clear their excess inventory. Multiple sourcescreate additional logistics issues that they would rather avoid. By using Overstock, manufacturers have a single source for thedistribution of excess inventory. •Improved control of distribution. By using Overstock, manufacturers can monitor what kind of customer, whether individual consumeror small retailer, ultimately purchases their merchandise. In addition, a manufacturer can request that its products be offered in onlyone of our sales channels in order to avoid sales channel pollution. •Improved transaction experience. By having a reliable inventory clearing channel, manufacturers are able to more quickly and easilydispense of their excess merchandise. Overstock also offers consumers a compelling alternative for bargain shopping. Key advantages for consumers include:•High quality and broad product selection. Most of the merchandise offered on our Websites is from well-known, brand-namemanufacturers. We typically have approximately 50,000 non-BMV products and approximately 500,000 BMV products (books,magazines, CDs, DVDs, video cassettes and video games) in eight major departments. •Convenient access on a secure site. Our customers are able to access and purchase our products 24 hours a day from theconvenience of their computer. We do not sell any personal information about our customer base to third parties. •Responsive customer service and positive shopping experience. Our team of customer service representatives (which includesemployees, temporary employees and outsourced staff) assists5 customers by telephone and e-mail. Our customer service staff answers approximately 85% of phone calls within 30 seconds, andresponds to approximately 98% of its e-mails within 12 hours. For our consumer business, we include a return shipment label in ourcustomer's shipment to facilitate product returns and, subject to certain conditions; we allow customers up to 20 days from date ofshipment to initiate the return of most purchased merchandise. In addition, we continually update and monitor our Websites toenhance the shopping experience for our customers. Our objective is to become the dominant closeout Internet-based solution for holders of brand-name merchandise, allowing them to disposeof that merchandise discreetly and with high recovery values, and to ultimately become a one-stop Internet-based discount shopping destination.We are pursuing this objective through the following key strategies:•Establish strong relationships with manufacturers. With the growth in the scale of our operations, we believe we are becoming anefficient liquidation channel for manufacturers and distributors. With scale comes the ability to buy in volume, and we believemanufacturers appreciate our ability to liquidate their products without disturbing their traditional channels. Generally, manufacturersdo not want their product offerings sold as heavily discounted, closeout products in brick-and-mortar retailers, as is common today.We believe that as manufacturers learn of our capabilities, they will increasingly recognize the attractiveness of Overstock as anefficient liquidation solution. •Optimize inventory management through the use of technology. Our merchandise buyers are supported by proprietary software thatprovides nearly instantaneous information on product sales, margins and inventory levels. This technology enables us to makeinformed decisions and quickly change prices in an effort to maximize sales volume, gross profits and return on inventory capital. •Optimize online marketing initiatives through the use of technology. Our marketing team is supported by proprietary software thatenhances the level of service provided to our customers and takes advantage of the unique characteristics of online distribution. Oursoftware provides us immediate feedback on the effectiveness of various marketing campaigns, allowing us to optimize our onlinemarketing expenditures. •Maintain low customer acquisition costs. We believe that by utilizing targeted online campaigns, including direct e-mail campaigns(the results of which we are able to quantify) as well as our internally developed national television and radio branding campaign, wewill be able to keep our per customer acquisition costs low.In addition, we use our books, music and videos (BMV) department as a tool to acquire customers at a low cost. We intentionallyprice this department with low margins in an effort to gain new customers efficiently, providing us the ability to introduce them toother products offered on our Website.•Membership programs. In March 2004, we launched our frequent buyer's club, Club O. Members of Club O pay an annual fee of$29.95 and receive a 5% discount on all non-travel and non-BMV products and $1 shipping per order, along with access to a specialcustomer service hotline. Additionally, in August 2004, we merged our B2B site (www.overstockb2b.com) into our B2C site, andopened a "Club O Gold" membership program (into which our current B2B customers were grandfathered). The terms of this programinclude a higher annual fee ($99.95), Club O Gold pricing (that is, our B2C price less 5% on single product purchases and steeperdiscounts for products purchased in bulk), and access to a special, small business-focused, customer service team. In addition, wehave formed an alliance with Advanta Corp. to assist us6 in promoting this program. We have added a number of suppliers specific to various industry verticals, such as florist supplies,restaurant supplies, and office supplies.Key Relationships Manufacturer, Supplier and Distribution Relationships. It is difficult to establish closeout buying relationships with manufacturers. Trust andexperience gained through past interactions are important. We believe our business model reduces the risk to the manufacturer that its discountedproducts are sold alongside its full-priced products. Our supplier relationships provide us with recognized, brand-name products. The table belowidentifies some of the brand names that generate significant revenues in various departments.AOL Time Warner Mai Random HouseBissell Meyer Corporation RCABlue Ridge Home Fashions Movado SamsoniteCuisinart Nicole Miller SeikoFuji Novica Simon & SchusterHewlett-Packard Linon Home Decor SonyKelty Panasonic Swiss ArmyKenneth Cole Philips Vera Wang To date, we have not entered into contracts with manufacturers or liquidation wholesalers that guarantee the availability of merchandise for aset duration. Our manufacturer and supplier relationships are based on historical experience with manufacturers and liquidation wholesalers and donot obligate or entitle us to receive merchandise on a long-term or short-term basis. In our direct business, we purchase the products frommanufacturers or liquidation wholesalers using standard purchase orders. Generally, suppliers do not control any of the terms under which productsare sold over our Websites. Fulfillment Partner Business. In our fulfillment partner business, we sell merchandise of other retailers, cataloguers or manufacturers("fulfillment partners") through our Websites. We currently have fulfillment partner relationships with approximately 380 third parties which postapproximately 40,000 non-BMV products and all of our current travel offerings on our Websites.Sales and Marketing We use a variety of methods to target our consumer audience, including online campaigns, such as advertising through portals, keywords,search engines, affiliate marketing relationships, banners and e-mail campaigns, and we are able to monitor and evaluate their results. We seek toidentify and eliminate campaigns that do not meet our expectations. We continued with our national television and radio branding campaignthroughout 2004, and plan to develop it further in 2005. We develop our branding campaigns internally, and we believe that doing so is cost-effective.7 ProductsOnline Products We offer products under 4 tabs: Shopping, Auctions, Travel and our Books, Music & Movies Tab. Currently, our products are organized intoeight different product departments on our Shopping Tab:Apparel, Shoes & Accessories Gifts & FlowersBooks, Music & Videos Jewelry & WatchesElectronics & Computers Recreation & SportsHome & Garden Worldstock Handcrafted Each of these departments has multiple categories that more specifically define the products offered within that department. For example,the following product categories are currently within the "Electronics & Computers" department:Audio & Video Home Office EquipmentCameras & Optics Computers & PrintersTelephones Each category has several subcategories that further detail the product contained within. For example, under the "Computers & Printers"category, we have the subcategories of "Computers," "Connectivity," "Drives & Storage," "Ink Cartridges," "Monitors," "PDA's & Handhelds,""Peripherals," "Printers & Scanners" and "Upgrades" and under the "PDA's & Handhelds" subcategory we have the further sub-subcategories of"Accessories," "Handspring," "Other Brands" and "Palm One." We historically operated a separate B2B Website. However, our direct revenue has predominantly been based on purchases made directlythrough our consumer Website. As a result, during the third quarter of 2004, we integrated the B2B Website into our consumer Website. B2Bclients now buy products primarily through our Club O frequent buyers club and our Club O Gold bulk purchase program. During 2004, no singlecustomer accounted for more than 1% of our total revenue. During September 2004, we added an online auction service to our Website. Our auction service allows sellers to list items for sale, buyersto bid on items of interest, and users to browse through listed items online. We are not the seller of the items sold on the auction site and we haveno control over the pricing of those items. Therefore, for auctions, we record only our listing fees for items listed and commissions for items soldas revenue. For the year ended December 31, 2004, our auction revenues were insignificant. During the first quarter of 2005, we reopened our discount travel store to our Website, currently offering cruise packages. In the future, weintend to offer other travel products such as flights, hotels, rental cars, etc. For the products or services that we sell in our travel store, we do notcurrently have inventory risk or pricing control, and do not directly provide customer service. Therefore, for these sales we are not considered to bethe primary obligor, and record only our commission as revenue. Individual products can be accessed and viewed from the category or subcategory pages. These specific product pages include detailedproduct descriptions, a color picture and pricing information. The number of total products we offer has grown from less than 100 in 1999, to more than 50,000 non-BMV products and approximately500,000 BMV products (books, magazines, CDs, DVDs, video cassettes and video games) as of December 31, 2004. As the number of productsand product categories change throughout the year, we periodically reorganize our departments and/or categories to better reflect our currentproduct offerings.8 Our Worldstock Website, at www.worldstock.com, is our Internet marketplace through which artisans in the United States and around theworld can sell their products and gain access to a broader market.Fulfillment Operations General. When customers place orders on our Websites, orders are fulfilled either by a third party fulfillment partner or directly from ourwarehouse in Salt Lake City, Utah or our outsourced warehouse located in Plainfield, Indiana. We monitor all of these sources for accurate orderfulfillment and timely shipment. We currently charge $2.95 for basic ground shipping, but customers can choose from various expedited shippingservices at their expense. Payment Terms. As a general policy, we require verification of receipt of payment or credit card authorization (including verifications fromPaypal and BillMeLater) before we ship products to consumers or business purchasers. From time to time we grant credit to our businesspurchasers with normal credit terms. Fulfillment for Direct Business. During 2004, we fulfilled approximately 40% of all orders through our leased Salt Lake City, Utah warehouseor our outsourced warehouse in Plainfield, Indiana. During 2004, the Salt Lake City warehouse team generally shipped between 10,000 and 12,000orders per day, and up to approximately 24,000 orders per day during peak periods, using overlapping daily shifts. We also process returns ofdirect and fulfillment partner merchandise in the Salt Lake City warehouse. Our warehouses store approximately 10,000 non-BMV products offeredon our Websites. We operate the Salt Lake City warehouse with an automated warehouse management system that tracks the receipt of theinventory items, distributes order-fulfillment assignments to warehouse workers and obtains rates for various shipping options to ensure low-costoutbound shipping. Our Websites relay orders to the warehouse management system throughout each day, and the warehouse managementsystem in turn confirms to our Websites shipment of each order. Customers track the shipping status of their packages through links we provideon our Websites. During 2004, we advertised a standard of shipping most of our orders within two business days of order placement, subject tocertain exceptions. Fulfillment Partner Business. During 2004 approximately 60% of our orders were for inventory owned and shipped by third party fulfillmentpartners. We currently manage approximately 380 entities that collect their orders through our Websites. These third parties perform essentially thesame operations as our warehouse: order picking and shipping; however, beginning July 1, 2003, we began handling returns for these sales. Thesethird parties relay shipment confirmations to our Websites, where customers can review shipping and tracking information. From a customer's pointof view, shipping from our warehouses or from the warehouse of one of these third parties is indistinguishable.Customer Service We are committed to superior customer service. We staff our customer service department with dedicated in-house and outsourcedprofessionals who respond to phone and e-mail inquiries on products, ordering, shipping status, and returns. Our customer service staff processesapproximately 20,000 to 25,000 calls per week. The same staff processes approximately 20,000 to 40,000 e-mail messages each week, with lessthan a 24-hour turnaround time. We use automated e-mail and phone systems to route traffic to appropriate customer service representatives. Thedemands on our customer service staff increase significantly during peak periods, including the several weeks before and after Christmas.9 Technology We use our internally developed Websites and a combination of proprietary technologies and commercially available licensed technologiesand solutions to support our operations. We use the services of XO Communications, Inc., Qwest Communications International, Inc. andMCI, Inc. to obtain connectivity to the Internet over two OC3s, and multiple Gig-E and OC48 links. We currently store our data on several Oracle 9iand 10g database clusters using Dell and IBM computer hardware connected to multiple large scale EMCs for high speed disk. Currently, we useDell PowerEdge servers for our Websites, which are connected to the Oracle database and operate in a multi-processing Linux environmentdesigned to accommodate large volumes of Internet traffic. During 2004 we moved our primary computer infrastructure to a co-location facility in Salt Lake City. We now use the computer facilitieslocated in the data center located at our corporate offices primarily for backups, redundancy, development, and testing.Competition The online liquidation services market is new, rapidly evolving, intensely competitive and has relatively low barriers to entry, as newcompetitors can launch new Websites at relatively low cost. We believe that competition in the online liquidation market is based predominantlyon:•price; •product quality and selection; •shopping convenience; •order processing and fulfillment; •customer service; and •brand recognition. Our liquidation services compete with other online retailers and traditional liquidation "brokers," some of which may specifically adopt ourmethods and target our customers. We currently or potentially compete with a variety of companies that can be divided into several broadcategories:•liquidation e-tailers such as SmartBargains; •online retailers with discount departments such as Amazon.com, Inc., eBay, Inc. and Buy.com, Inc.; and •traditional retailers and liquidators such as Ross Stores, Inc., Walmart Stores, Inc. and TJX Companies, Inc. As the market for online liquidation grows, we believe that companies involved in online retail, as well as traditional retailers and liquidationbrokers, will increase their efforts to develop services that compete with our online services. We also face potential competition from Internetcompanies not yet focused on the liquidation market, and from retail companies not yet operating online. We are unable to anticipate which othercompanies are likely to offer services in the future that will compete with the services we provide.10 In addition, many of our current and potential competitors have greater brand recognition, longer operating histories, larger customer basesand significantly greater financial, marketing and other resources than us, and may enter into strategic or commercial relationships with larger,more established and well-financed companies. Some of our competitors could enter into exclusive distribution arrangements with our vendors anddeny us access to their products, devote greater resources to marketing and promotional campaigns and devote substantially more resources totheir Website and systems development than our company. New technologies and the continued enhancement of existing technologies also mayincrease competitive pressures on our company. We cannot assure you that we will be able to compete successfully against current and futurecompetitors or address increased competitive pressures. See "Risk Factors."Intellectual Property We regard our domain names and similar intellectual property as critical to our success. We rely on a combination of laws and contractualrestrictions with our employees, customers, suppliers, affiliates and others to establish and protect our proprietary rights. Despite theseprecautions, it may be possible for a third party to copy or otherwise obtain and use our intellectual property without authorization. In addition, wecannot assure you that others will not independently develop similar intellectual property. Although we are pursuing the registration of our keytrademarks in the United States, some of our trade names are not eligible to receive trademark protection. In addition, effective trademarkprotection may not be available or may not be sought by us in every country in which our products and services are made available online,including the United States. From time to time, we may be subject to legal proceedings and claims in the ordinary course of our business, including claims of allegedinfringement of the trademarks and other intellectual property rights of third parties by our company. For example, in October 2003, Tiffany(NJ) Inc. and Tiffany and Company filed a complaint against us in the United States District Court for the Southern District of New York allegingthat we have distributed counterfeit and otherwise unauthorized Tiffany product in violation of federal copyright and trademark law and related statelaws. The complaint seeks statutory and other damages in an unspecified amount and injunctive relief. In January 2005, Tiffany (NJ) Inc. andTiffany and Company filed four additional complaints against us in the United States District Court for the Southern District of New York allegingthat we have distributed counterfeit and otherwise unauthorized Tiffany product in violation of federal copyright and trademark law and related statelaws. Although we believe we have defenses to the allegations and intend to pursue them vigorously, we do not have sufficient information toassess the validity of the claims or the amount of potential damages. See "Legal Proceedings" for additional information regarding our lawsuitswith Tiffany and other third parties. These and other types of claims could result in increased costs of doing business through legal expenses, adverse judgments or settlementsor require us to change our business practices in expensive ways. In addition, litigation could result in interpretations of the law that require us tochange our business practices or otherwise increase our costs. Third parties have in the past, and may in the future, recruit our employees who have had access to our proprietary technologies, processesand operations. These recruiting efforts expose us to the risk that such employees will misappropriate our intellectual property. Additional litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets or to determine thevalidity and scope of the proprietary rights of others. Any litigation, regardless of outcome or merit, could result in substantial costs and diversionof management and technical resources, any of which could materially harm our business. See "Risk Factors."11 Government Regulation All of our services are subject to federal and state consumer protection laws including laws protecting the privacy of consumer non-publicinformation and regulations prohibiting unfair and deceptive trade practices. In particular, under federal and state financial privacy laws andregulations, we must provide notice to consumers of our policies on sharing non-public information with third parties, must provide advance noticeof any changes to our policies and, with limited exceptions, must give consumers the right to prevent sharing of their non-public personalinformation with unaffiliated third parties. Furthermore, the growth and demand for online commerce could result in more stringent consumerprotection laws that impose additional compliance burdens on online companies. These consumer protection laws could result in substantialcompliance costs and could interfere with the conduct of our business. In January 2005, we received an inquiry from the Federal Trade Commission ("FTC") regarding our shipping policies and systems and othermatters. We are cooperating fully with the FTC's inquiry. We are currently unable to determine the potential outcome of this inquiry. In many states, there is currently great uncertainty whether or how existing laws governing issues such as property ownership, sales andother taxes, libel and personal privacy apply to the Internet and commercial online services. These issues may take years to resolve. In addition,new state tax regulations may subject us to additional state sales and income taxes. New legislation or regulation, the application of laws andregulations from jurisdictions whose laws do not currently apply to our business or the application of existing laws and regulations to the Internetand commercial online services could result in significant additional taxes on our business. These taxes could have an adverse effect on our cashflows and results of operations. Furthermore, there is a possibility that we may be subject to significant fines or other payments for any pastfailures to comply with these requirements.Employees As of December 31, 2004, we had 426 full-time employees, including 48 in customer service and fraud prevention, 131 in order fulfillment, 49in information technology and Website production, 36 in marketing, 113 in merchandising and auctions, 29 in accounting and finance, and 20 in ourexecutive and administrative department. We have never had a work stoppage, and none of our employees are represented by a labor union. Weconsider our employee relationships to be positive.Risk Factors Any investment in our securities involves a high degree of risk. Investors should consider carefully the risks and uncertainties describedbelow, and all other information in this Form 10-K and in any reports we file with the SEC after we file this Form 10-K, before deciding whether topurchase or hold our securities. Additional risks and uncertainties not currently known to us or that we currently deem immaterial may also becomeimportant factors that may harm our business. The occurrence of any of the following risks could harm our business. The trading price of oursecurities could decline due to any of these risks and uncertainties, and investors may lose part or all of their investment.Risks Relating to OverstockWe have a history of significant losses. If we do not achieve profitability, our financial condition and our stock price could suffer. We have a history of losses and we may continue to incur operating and net losses for the foreseeable future. We incurred net lossesattributable to common shares of $12.1 million and $5.2 million for the years ended December 31, 2003 and 2004, respectively. As ofDecember 31, 2003, and 2004, our accumulated deficit was $67.8 million and $73.0 million, respectively. We will need to12 generate significant revenues to achieve profitability, and we may not be able to do so. Even if we do achieve profitability, we may not be able tosustain or increase profitability on a quarterly or annual basis in the future. If our revenues grow more slowly than we anticipate, or if our operatingexpenses exceed our expectations, our financial results would be harmed. We will continue to incur significant operating expenses and capital expenditures as we:•enhance our distribution and order fulfillment capabilities; •further improve our order processing systems and capabilities; •develop enhanced technologies and features; •expand our customer service capabilities to better serve our customers' needs; •expand our product offerings, including our auctions site, our travel site and our custom design jewelry site; •rent additional warehouse and office space; •increase our general and administrative functions to support our operations; and •maintain or increase our sales, branding and marketing activities, including maintaining existing or entering into new online marketingarrangements, and continuing or increasing our national television and radio branding campaigns. Because we will incur many of these expenses before we receive any revenues from our efforts, our losses may be greater than the losseswe would incur if we developed our business more slowly. Further, we base our expenses in large part on our operating plans and future revenueprojections. Many of our expenses are fixed in the short term, and we may not be able to quickly reduce spending if our revenues are lower thanwe project. Therefore, any significant shortfall in revenues would likely harm our business, prospects, operating results and financial condition. Inaddition, we may find that these efforts are more expensive than we currently anticipate, which would further increase our losses. Also, the timingof these expenses may contribute to fluctuations in our quarterly operating results.If we fail to accurately forecast our expenses and revenues, our business, operating results and financial condition may suffer and theprice of our stock may decline. Our limited operating history and the rapidly evolving nature of our industry make forecasting operating results difficult. We may not be ableto quickly reduce spending if our revenues are lower than we project. Therefore, any significant shortfall in revenues would likely harm ourbusiness, prospects, operating results and financial condition and cause our results of operation to fall below the expectations of public marketanalysts and investors. If this occurs, the price of our securities may decline.We depend on our relationships with third party fulfillment partners for a large portion of the products that we offer for sale on ourWebsites. If we fail to maintain these relationships, our business will suffer. During 2004, we had fulfillment partner relationships with approximately 380 third parties whose products we offer for sale on our Websites.At December 31, 2004, these products accounted for approximately 80% of the non-BMV products available on our Websites. We do not have anylong-term agreements with any of these third parties. Our agreements with third parties are terminable at will by either party immediately uponnotice. In general, we agree to offer the third parties' products on our Websites and these third parties agree to provide us with information abouttheir products, honor our customer service policies and ship the products directly to the customer. If we do not maintain our existing or build newrelationships with third parties on acceptable commercial terms, we may not be able to offer a broad selection of merchandise, and customers mayrefuse to shop at our Websites. In13 addition, manufacturers may decide not to offer particular products for sale on the Internet. If we are unable to maintain our existing or build newfulfillment partner relationships or if other product manufacturers refuse to allow their products to be sold via the Internet, our business andprospects would suffer severely.We are partially dependent on third parties to fulfill a number of our fulfillment, distribution and other retail functions. If such parties areunwilling or unable to continue providing these services, our business could be seriously harmed. In our fulfillment partner business, although we now handle returned merchandise, we continue to rely on third parties to conduct a number ofother traditional retail operations with respect to their respective products that we offer for sale on our Websites, including maintaining inventory,preparing merchandise for shipment to individual customers and timely distribution of purchased merchandise. We have no effective means toensure that these third parties will continue to perform these services to our satisfaction or on commercially reasonable terms. In addition,because we do not take possession of these third parties' products, we are unable to fulfill these traditional retail operations ourselves. Ourcustomers could become dissatisfied and cancel their orders or decline to make future purchases if these third parties are unable to deliverproducts on a timely basis. If our customers become dissatisfied with the services provided by these third parties, our reputation and theOverstock.com brand could suffer.We rely on our relationships with manufacturers, retailers and other suppliers to obtain sufficient quantities of quality merchandise onacceptable terms. If we fail to maintain our supplier relationships on acceptable terms, our sales and profitability could suffer. To date, we have not entered into contracts with manufacturers or liquidation wholesalers that guarantee the availability of merchandise for aset duration. Our contracts or arrangements with suppliers do not provide for the continuation of particular pricing practices and may be terminatedby either party at any time. Our current suppliers may not continue to sell their excess inventory to us on current terms or at all, and we may notbe able to establish new supply relationships. For example, it is difficult for us to maintain high levels of product quality and selection becausenone of the manufacturers, suppliers and liquidation wholesalers from whom we purchase products on a purchase order by purchase order basishave a continuing obligation to provide us with merchandise at historical levels or at all. In most cases, our relationships with our suppliers do notrestrict the suppliers from selling their respective excess inventory to other traditional or online merchandise liquidators, which could in turn limitthe selection of products available on our Websites. If we are unable to develop and maintain relationships with suppliers that will allow us toobtain sufficient quantities of merchandise on acceptable commercial terms, such inability could harm our business, prospects, results ofoperation and financial condition.We depend upon third-party delivery services to deliver our products to our customers on a timely and consistent basis. A deteriorationin our relationship with any one of these third parties could decrease our ability to track shipments, cause shipment delays, andincrease our shipping costs and the number of damaged products. We rely upon multiple third parties for the shipment of our products. Because we do not have a written long-term agreement with any of thesethird parties, we cannot be sure that these relationships will continue on terms favorable to us, if at all. Unexpected increases in shipping costs ordelivery times, particularly during the holiday season, could harm our business, prospects, financial condition and results of operations. If ourrelationships with these third parties are terminated or impaired or if these third parties are unable to deliver products for us, whether through laborshortage, slow down or stoppage, deteriorating financial or business condition, responses to terrorist attacks or for any other reason, we would berequired to use alternative carriers for the shipment of products to our customers. In addition, conditions such as adverse weather can prevent anycarriers from performing their delivery14 services, which can have an adverse effect on our customers' satisfaction with us. In any of these circumstances, we may be unable to engagealternative carriers on a timely basis, upon terms favorable to us, or at all. Changing carriers would likely have a negative effect on our business,prospects, operating results and financial condition. Potential adverse consequences include:•reduced visibility of order status and package tracking; •delays in order processing and product delivery; •increased cost of delivery, resulting in reduced gross margins; and •reduced shipment quality, which may result in damaged products and customer dissatisfaction.A significant number of merchandise returns could harm our business, financial condition and results of operations. We allow our customers to return products and, beginning July 1, 2003, we started accepting returns of products sold through our fulfillmentpartners. We modify our policies relating to returns from time to time, and any policies intended to reduce the number of product returns may resultin customer dissatisfaction and fewer return customers. If merchandise returns are significant, our business, prospects, financial condition andresults of operations could be harmed.If the products that we offer on our Websites do not reflect our customers' tastes and preferences, our sales and profit margins woulddecrease. Our success depends in part on our ability to offer products that reflect consumers' tastes and preferences. Consumers' tastes are subject tofrequent, significant and sometimes unpredictable changes. Because the products that we sell typically consist of manufacturers' and retailers'excess inventory, we have limited control over the specific products that we are able to offer for sale. If our merchandise fails to satisfycustomers' tastes or respond to changes in customer preferences, our sales could suffer and we could be required to mark down unsold inventorywhich would depress our profit margins. In addition, any failure to offer products in line with customers' preferences could allow our competitors togain market share. This could have an adverse effect on our business, prospects, results of operations and financial condition.We face risks relating to our inventory. We directly purchase some of the merchandise that we sell on our Websites. We assume the inventory damage, theft and obsolescencerisks, as well as price erosion risks for products that we purchase directly. These risks are especially significant because some of themerchandise we sell on our Websites are characterized by rapid technological change, obsolescence and price erosion (for example, computerhardware, software and consumer electronics), and because we sometimes make large purchases of particular types of inventory. In addition, weoften do not receive warranties on the merchandise we purchase. Further, beginning July 1, 2003, we started accepting returns of products soldthrough our fulfillment partners, and we have the risk of reselling the returned products. In the recent past, we have recorded charges for obsolete inventory and have had to sell certain merchandise at a discount or loss. It isimpossible to determine with certainty whether an item will sell for more than the price we pay for it. Because we rely heavily on purchasedinventory, our success will depend on our ability to liquidate our inventory rapidly, the ability of our buying staff to purchase inventory at attractiveprices relative to its resale value and our ability to manage customer returns and the shrinkage resulting from theft, loss and misrecording ofinventory. If we are unsuccessful in any of these areas, we may be forced to sell our inventory at a discount or loss.15 We have grown quickly and if we fail to manage our growth, our business will suffer. We have rapidly and significantly expanded our operations, and anticipate that further significant expansion will be required to addresspotential growth in our customer base and market opportunities. This expansion has placed, and is expected to continue to place, a significantstrain on our management, operational and financial resources. Some of our officers have no prior senior management experience at publiccompanies. Our new employees include a number of key managerial, technical and operations personnel, and we expect to add additional keypersonnel in the future. To manage the expected growth of our operations and personnel, we will be required to improve existing and implementnew transaction-processing, operational and financial systems, procedures and controls, and to expand, train and manage our already growingemployee base. If we are unable to manage growth effectively, our business, prospects, financial condition and results of operations will beharmed.The loss of key personnel or any inability to attract and retain additional personnel could affect our ability to successfully grow ourbusiness. Our performance is substantially dependent on the continued services and on the performance of our senior management and other keypersonnel, particularly Patrick M. Byrne, our President and Chairman of the Board. Our performance also depends on our ability to retain andmotivate other officers and key employees. The loss of the services of any of our executive officers or other key employees for any unforeseenreason, including without limitation, illness or call to military service, could harm our business, prospects, financial condition and results ofoperations. We do not have employment agreements with any of our key personnel and we do not maintain "key person" life insurance policies.Our future success also depends on our ability to identify, attract, hire, train, retain and motivate other highly-skilled technical, managerial,editorial, merchandising, marketing and customer service personnel. Competition for such personnel is intense, and we cannot assure you that wewill be able to successfully attract, assimilate or retain sufficiently qualified personnel. Our failure to retain and attract the necessary technical,managerial, editorial, merchandising, marketing and customer service personnel could harm our revenues, business, prospects, financial conditionand results of operations.We may be unable to manage expansion into new business areas which could harm our business operations and reputation. Our long-term strategic plan involves expansion of our operations to offer additional types of products and services. We cannot assure youthat our efforts to expand our business in this manner will succeed. Because we were unable to generate significant traffic for our former B2B site,in the third quarter of 2004, we merged the B2B site into our main website, and opened our "Club O Gold" bulk purchase program. Our failure tosucceed in this market or other markets or other product or service offerings may harm our business, prospects, financial condition and results ofoperation. We cannot assure you that we will be able to expand our operations in a cost-effective or timely manner or that our efforts to expand willbe successful. Furthermore, any new business or Website we launch that is not favorably received by consumers could damage our reputation orthe Overstock.com brand. We may expand the number of categories of products we carry on our Websites, and these and any other expansions ofour operations would also require significant additional expenses and development and would strain our management, financial and operationalresources. The lack of market acceptance of such efforts or our inability to generate satisfactory revenues from such expanded services orproducts to offset their cost could harm our business, prospects, financial condition and results of operations.16 We may expand our international business, causing our business to become increasingly susceptible to numerous internationalbusiness risks and challenges that could affect our profitability. We have begun to expand into international markets, and in the future we may do so more aggressively. International sales and transactionsare subject to inherent risks and challenges that could adversely affect our profitability, including:•the need to develop new supplier and manufacturer relationships; •the need to comply with additional laws and regulations to the extent applicable; •unexpected changes in international regulatory requirements and tariffs; •difficulties in staffing and managing foreign operations; •longer payment cycles from credit card companies; •greater difficulty in accounts receivable collection; •potential adverse tax consequences; •price controls or other restrictions on foreign currency; and •difficulties in obtaining export and import licenses. To the extent we generate international sales and transactions in the future, any negative impact on our international operations couldnegatively impact our business. In particular, gains and losses on the conversion of foreign payments into United States dollars may contribute tofluctuations in our results of operations and fluctuating exchange rates could cause reduced gross revenues and/or gross margins from non-dollar-denominated international sales.In order to obtain future revenue growth and achieve and sustain profitability we will have to attract customers on cost-effective terms. Our success depends on our ability to attract customers on cost-effective terms. We have relationships with online services, search engines,directories and other Websites and e-commerce businesses to provide content, advertising banners and other links that direct customers to ourWebsites. We rely on these relationships as significant sources of traffic to our Websites and to generate new customers. If we are unable todevelop or maintain these relationships on acceptable terms, our ability to attract new customers and our financial condition could be harmed. Inaddition, certain of our online marketing agreements may require us to pay upfront fees and make other payments prior to the realization of thesales, if any, associated with those payments. Accordingly, if these agreements or similar agreements that we may enter into in the future fail toproduce the sales that we anticipate, our results of operations will be adversely affected. We cannot assure you that we will be able to increase ourrevenues, if at all, in a cost-effective manner. We periodically conduct national television and radio branding and advertising campaigns. Suchcampaigns are expensive and may not result in the cost effective acquisition of customers. Further, many of the parties with which we may have online-advertising arrangements could provide advertising services for other online ortraditional retailers and merchandise liquidators. As a result, these parties may be reluctant to enter into or maintain relationships with us. Failureto achieve sufficient traffic or generate sufficient revenue from purchases originating from third parties may result in termination of theserelationships by these third parties. Without these relationships, our revenues, business, prospects, financial condition and results of operationscould suffer.17 We may not be able to compete successfully against existing or future competitors. The online liquidation services market is new, rapidly evolving and intensely competitive. Barriers to entry are minimal, and current and newcompetitors can launch new Websites at a relatively low cost. Our consumer Website currently competes with:•other online liquidation e-tailers, such as SmartBargains; •traditional retailers and liquidators, such as Ross Stores, Inc., Walmart Stores, Inc. and TJX Companies, Inc.; and •online retailers and marketplaces such as Amazon.com, Inc., Buy.com, Inc. and eBay, Inc., which have discount departments.Our Website competes with liquidation "brokers" and retailers and online marketplaces such as eBay, Inc. We expect the online liquidation services market to become even more competitive as traditional liquidators and online retailers continue todevelop services that compete with our services. In addition, manufacturers and retailers may decide to create their own Websites to sell their ownexcess inventory and the excess inventory of third parties. Competitive pressures created by any one of our competitors, or by our competitorscollectively, could harm our business, prospects, financial condition and results of operations. Further, as a strategic response to changes in the competitive environment, we may from time to time make certain pricing, service ormarketing decisions or acquisitions that could harm our business, prospects, financial condition and results of operations. For example, to theextent that we enter new lines of businesses such as third-party logistics, or discount brick and mortar retail, we would be competing with largeestablished businesses such as APL Logistics, Ltd., Ross Stores, Inc. and TJX Companies, Inc., respectively. We have recently entered theonline auctions business in which we compete with large established businesses including eBay, Inc. Many of our current and potential competitors described above have longer operating histories, larger customer bases, greater brandrecognition and significantly greater financial, marketing and other resources than we do. In addition, online retailers and liquidation e-tailers maybe acquired by, receive investments from or enter into other commercial relationships with larger, well-established and well-financed companies.Some of our competitors may be able to secure merchandise from manufacturers on more favorable terms, devote greater resources to marketingand promotional campaigns, adopt more aggressive pricing or inventory availability policies and devote substantially more resources to Websiteand systems development than we do. Increased competition may result in reduced operating margins, loss of market share and a diminishedbrand franchise. We cannot assure you that we will be able to compete successfully against current and future competitors.Our operating results depend on our Websites, network infrastructure and transaction-processing systems. Capacity constraints orsystem failures would harm our business, prospects, results of operations and financial condition. Any system interruptions that result in the unavailability of our Websites or reduced performance of our transaction systems would reduceour transaction volume and the attractiveness of the services that we provide to suppliers and third parties and would harm our business,prospects, operating results and financial condition. We use internally developed systems for our Websites and certain aspects of transaction processing, including customer profiling and orderverifications. We have experienced periodic systems interruptions due to server failure, which we believe will continue to occur from time to time.If the volume of traffic on our Websites or the number of purchases made by customers substantially18 increases, we will need to further expand and upgrade our technology, transaction processing systems and network infrastructure. We haveexperienced and expect to continue to experience temporary capacity constraints due to sharply increased traffic during sales or other promotionsand during the holiday shopping season. Capacity constraints can cause unanticipated system disruptions, slower response times, degradation inlevels of customer service, impaired quality and delays in reporting accurate financial information. Our transaction processing systems and network infrastructure may be unable to accommodate increases in traffic in the future. We may beunable to project accurately the rate or timing of traffic increases or successfully upgrade our systems and infrastructure to accommodate futuretraffic levels on our Websites. In addition, we may be unable to upgrade and expand our transaction processing systems in an effective and timelymanner or to integrate any newly developed or purchased functionality with our existing systems. Any inability to do so may cause unanticipatedsystem disruptions, slower response times, degradation in levels of customer service, impaired quality and speed of order fulfillment or delays inreporting accurate financial information.If the facilities where substantially all of our computer and communications hardware is located fail, our business, results of operationsand financial condition will be harmed. Our success, and, in particular, our ability to successfully receive and fulfill orders and provide high-quality customer service, largelydepends on the efficient and uninterrupted operation of our computer and communications systems. Substantially all of our computer andcommunications hardware is located at a single co-location facility in Salt Lake City, Utah, with a partially redundant back-up system located atour corporate headquarters in Salt Lake City. Although we have designed our back-up system in an effort to avoid or minimize service interruptionsin the event of a failure of our main facility, our systems and operations are vulnerable to damage or interruption from fire, flood, power loss,telecommunications failure, terrorist attacks, acts of war, break-ins, earthquake and similar events. We do not have a formal disaster recoveryplan and our business interruption insurance may be insufficient to compensate us for losses that may occur. Despite the implementation ofnetwork security measures, our servers are vulnerable to computer viruses, physical or electronic break-ins and similar disruptions, which couldlead to interruptions, delays, loss of critical data or the inability to accept and fulfill customer orders. The occurrence of any of the foregoing riskscould harm our business, prospects, financial condition and results of operations.We may be unable to protect our proprietary technology or keep up with that of our competitors. Our success depends to a significant degree upon the protection of our software and other proprietary intellectual property rights. We may beunable to deter misappropriation of our proprietary information, detect unauthorized use and take appropriate steps to enforce our intellectualproperty rights. In addition, our competitors could, without violating our proprietary rights, develop technologies that are as good as or better thanour technology. Our failure to protect our software and other proprietary intellectual property rights or to develop technologies that are as good as ourcompetitors' could put us at a disadvantage to our competitors. In addition, the failure of the third parties whose products we offer for sale on ourWebsites to protect their intellectual property rights, including their domain names, could impair our operations. These failures could harm ourbusiness, results of operations and financial condition.If we do not respond to rapid technological changes, our services could become obsolete and we could lose customers. To remain competitive, we must continue to enhance and improve the functionality and features of our e-commerce businesses. We mayface material delays in introducing new services, products and enhancements. If this happens, our customers may forgo the use of our Websitesand use those of our competitors. The Internet and the online commerce industry are rapidly changing. If competitors19 introduce new products and services using new technologies or if new industry standards and practices emerge, our existing Websites and ourproprietary technology and systems may become obsolete. Our failure to respond to technological change or to adequately maintain, upgrade anddevelop our computer network and the systems used to process customers' orders and payments could harm our business, prospects, financialcondition and results of operations.We may not be able to obtain trademark protection for our marks, which could impede our efforts to build brand identity. We have filed trademark applications with the Patent and Trademark Office seeking registration of certain service marks or trademarks.There can be no assurance that our applications will be successful or that we will be able to secure significant protection for our service marks ortrademarks in the United States or elsewhere as we expand internationally. Our competitors or others could adopt product or service marks similarto our marks, or try to prevent us from using our marks, thereby impeding our ability to build brand identity and possibly leading to customerconfusion. Any claim by another party against us or customer confusion related to our trademarks, or our failure to obtain trademark registration,could negatively affect our business.We may not be able to enforce protection of our intellectual property rights under the laws of other countries. As we continue to expand internationally, we are subject to risks of doing business internationally as related to our intellectual property,including:•legal uncertainty regarding liability for the listings and other content provided by our users, including uncertainty as a result of lessInternet-friendly legal systems, unique local laws, and lack of clear precedent or applicable law; and •differing intellectual property laws, which may provide insufficient protection for our intellectual property.Our business and reputation may be harmed by the listing or sale of pirated, counterfeit or illegal items by third parties, and byintellectual property litigation. We have received in the past, and we anticipate we will receive in the future, communications alleging that certain items listed or soldthrough our Websites infringe third-party copyrights, trademarks and trade names or other intellectual property rights or that we have otherwiseinfringed third parties' past, current or future intellectual property rights. For example, in October 2003, Tiffany (NJ) Inc. and Tiffany and Companyfiled a complaint against us in the United States District Court for the Southern District of New York alleging that we have distributed counterfeitand otherwise unauthorized Tiffany product in violation of federal copyright and trademark law and related state laws. In addition, in January 2005,Tiffany filed additional complaints against us asserting similar claims. See "Legal Proceedings" for additional information regarding our lawsuitswith Tiffany and other third parties. We may be unable to prevent third parties from listing unlawful goods, and we may be subject to allegations of civil or criminal liability forunlawful activities carried out by third parties through our Websites. In the future, we may implement measures to protect against these potentialliabilities that could require us to spend substantial resources and/or to reduce revenues by discontinuing certain service offerings. Any costsincurred as a result of liability or asserted liability relating to the sale of unlawful goods or the unlawful sale of goods could harm our revenues,business, prospects, financial condition and results of operations. Resolving litigation or claims regarding patents or other intellectual property, whether meritorious or not, could be costly, time-consuming,cause service delays, divert our management and key personnel from our business operations, require expensive or unwanted changes in ourmethods of doing business20 or require us to enter into costly royalty or licensing agreements, if available. As a result, these claims could harm our business. Negative publicity generated as a result of the foregoing could damage our reputation, harm our business and diminish the value of our brandname.We may be liable if third parties misappropriate our customers' personal information. If third parties are able to penetrate our network security or otherwise misappropriate our customers' personal information or credit cardinformation, or if we give third parties improper access to our customers' personal information or credit card information, we could be subject toliability. This liability could include claims for unauthorized purchases with credit card information, impersonation or other similar fraud claims. Thisliability could also include claims for other misuses of personal information, including unauthorized marketing purposes. These claims could resultin litigation. Liability for misappropriation of this information could adversely affect our business. In addition, the Federal Trade Commission andstate agencies have been investigating various Internet companies regarding their use of personal information. We could incur additional expensesif new regulations regarding the use of personal information are introduced or if government agencies investigate our privacy practices. We rely on encryption and authentication technology licensed from third parties to provide the security and authentication necessary to effectsecure transmission of confidential information such as customer credit card numbers. We cannot assure you that advances in computercapabilities, new discoveries in the field of cryptography or other events or developments will not result in a compromise or breach of thealgorithms that we use to protect customer transaction data. If any such compromise of our security were to occur, it could harm our reputation,business, prospects, financial condition and results of operations. A party who is able to circumvent our security measures could misappropriateproprietary information or cause interruptions in our operations. We may be required to expend significant capital and other resources to protectagainst such security breaches or to alleviate problems caused by such breaches. We cannot assure you that our security measures will preventsecurity breaches or that failure to prevent such security breaches will not harm our business, prospects, financial condition and results ofoperations.We may be subject to product liability claims that could be costly and time consuming. We sell products manufactured by third parties, some of which may be defective. If any product that we sell were to cause physical injury orinjury to property, the injured party or parties could bring claims against us as the retailer of the product. Our insurance coverage may not beadequate to cover every claim that could be asserted. If a successful claim were brought against us in excess of our insurance coverage, it couldadversely affect our business. Even unsuccessful claims could result in the expenditure of funds and management time and could have a negativeimpact on our business.We have significant indebtedness. In connection with our sale of our 3.75% Convertible Senior Notes (the "notes") in November 2004, we incurred $120,000,000 ofindebtedness. As a result of this indebtedness, our principal and interest payment obligations increased substantially. The degree to which we willbe leveraged could materially and adversely affect our ability to obtain additional financing for working capital, acquisitions or other purposes andcould make us more vulnerable to industry downturns and competitive pressures. Our ability to meet our debt service obligations will be dependentupon our future performance, which will be subject to financial, business and other factors affecting our operations, many of which are beyond ourcontrol.21 We may be unable to generate sufficient cash flow to satisfy our debt service obligations. Our ability to generate cash flow from operations to make interest payments on our debt obligations will depend on our future performance,which will be affected by a range of economic, competitive and business factors. We cannot control many of these factors, including generaleconomic conditions and the health of the internet retail industry. If our operations do not generate sufficient cash flow from operations to satisfyour debt service obligations, we may need to borrow additional funds to make these payments or undertake alternative financing plans, such asrefinancing or restructuring our debt, or reducing or delaying capital investments and acquisitions. Additional funds or alternative financing may notbe available to us on favorable terms, or at all. Our inability to generate sufficient cash flow from operations or obtain additional funds or alternativefinancing on acceptable terms could have a material adverse effect on our business, prospects, financial condition and results of operations.Issuances of our securities are subject to federal and state securities laws, and certain holders of common stock issued by us may beentitled to rescind their purchases. Issuances of securities are subject to federal and state securities laws. From November 1999 through September 2000, we offered and soldcommon stock to investors in various states. Certain of those offerings may not have complied with various requirements of applicable statesecurities laws. In such situations a number of remedies may be available to regulatory authorities and the investors who purchased commonstock in those offerings, including, without limitation, a right of rescission, civil penalties, seizure of our assets, a restraining order or injunction,and a court order to pay restitution and costs. As a result, certain investors in our common stock may be entitled to return their shares toOverstock.com and receive from us the full price they paid, plus interest, which we estimate to be an aggregate amount of approximately$3.2 million at December 31, 2004.Risks Relating to our Auctions Site BusinessOur auctions site is a new business. Our auctions site began operation in September 2004. The online auctions business is a new business for us, and we cannot assure you thatour expansion into the online auctions business will succeed. Our entry into the online auctions business will require us to devote substantialfinancial, technical, managerial and other resources to the business. It will also expose us to additional risks, including legal and regulatory risks,and will require us to compete with established businesses having substantially greater experience in the online auctions business andsubstantially greater resources than we do.Our auction business may be subject to a variety of regulatory requirements. Many states and other jurisdictions, including Utah, where our company is located, have regulations governing the conduct of traditional"auctions" and the liability of traditional "auctioneers" in conducting auctions. Although the vast majority of these regulations clearly contemplatedonly traditional auctions, and did not contemplate online auctions, the potential application of these types of regulations to online auction sites isnot clear. We are aware that several states and some foreign jurisdictions have attempted to impose such regulations on other companiesoperating online auction sites or on the users of those sites. In addition, certain states have laws or regulations that do expressly apply to onlineauction site services. Although we do not expect these laws to have a significant effect on our auction site business, we will incur costs incomplying with these laws, and we may from time to time be required to make changes in our business that may increase our costs, reduce ourrevenues, cause us to prohibit the listing of certain items in certain locations, or make other changes that may adversely affect our auctionsbusiness.22 Current and future laws could affect our auctions business. Like our shopping site business, our auction site business is subject to the same laws and regulations as apply to other companiesconducting business on and off the Internet. In addition, our auction site business may be affected by other laws and regulations, such as thosethat expressly apply to online auction site services. Further, because of the wide range of items that users of our auctions service may choose tolist on the site, a variety of additional laws and regulations may apply to transactions between users of our site, such as those requiring a licenseto sell or purchase certain items or mandating particular disclosures in connection with an offer or sale of an item. To the extent that such currentor future laws or regulations prevent users from selling items on our auction site, they could harm our business.Our business may be harmed if our auction site is used for unlawful transactions. The law regarding the potential liability of an online auction service for the activities of its users is not clear. We prohibit the listing ofnumerous categories of items in an effort to reduce the possibility that users of our auction site will engage in an unlawful transaction. However,we cannot assure that users of the site will comply with all laws and regulations applicable to them and their transactions, and we may be subjectto allegations of civil or criminal liability for any unlawful activities conducted by them. Any costs we incur as a result of any such allegations, oras a result of actual or alleged unlawful transactions utilizing our site, or in our efforts to prevent any such transactions, may harm our business. Inaddition, any negative publicity we receive regarding any such transactions or allegations may damage our reputation, our ability to attract newcustomers to our main shopping site, and the Overstock.com brand name generally.Fraudulent activities using our auctions site and disputes between users of our auctions site may harm our business. We are aware that other companies operating online auction services have periodically received complaints from users alleging that theyhave not received the purchase price or the goods they expected to receive, and that in some cases users have been arrested and convicted forengaging in fraudulent activities using those companies' auction sites. We may receive similar complaints. We do not have the ability to requireusers of our services to fulfill their obligations to make payments or to deliver items. We are aware that other companies periodically receivecomplaints from buyers about the quality of the items they purchase, requests for reimbursement of amounts paid, and communicationsthreatening or commencing legal actions against them. We may receive similar complaints, requests and communications in connection with ourauctions site business.We are subject to risks associated with information transmitted through our service. The law relating to the liability of online services companies for information carried on or disseminated through their services is currentlyunsettled. Claims could be made against online services companies under both U.S. and foreign law for defamation, libel, invasion of privacy,negligence, copyright or trademark infringement, or other theories based on the nature and content of the materials disseminated through theirservices. We are aware that private lawsuits seeking to impose liability under a number of these theories have been brought against othercompanies operating auction sites. In addition, domestic and foreign legislation has been proposed that would prohibit or impose liability for thetransmission over the Internet of certain types of information. Our service permits users to make comments regarding other users. Although allsuch comments are generated by users and not by us, we are aware that claims of defamation or other injury have been made against othercompanies operating auction services in the past and could be made in the future against us for comments made by users. Recent court decisionshave narrowed the scope of the immunity provided to Internet service providers like us under the Communications Decency Act. This trend, ifcontinued, may increase our potential liability to third parties for the user-provided content on our site.23 Difficulties or negative publicity associated with our auctions business could affect our main shopping site business. Any significant operational or other difficulties we encounter with our auctions business could damage our reputation, our ability to attract newcustomers to our main shopping site, and the Overstock.com brand name generally. Negative publicity resulting from actual or alleged fraudulentor deceptive conduct by users of our auctions site could also damage our reputation, our ability to attract new customers to our main shoppingsite, and the Overstock.com brand name generally.Risks Relating to the Internet IndustryOur success is tied to the continued use of the Internet and the adequacy of the Internet infrastructure. Our future revenues and profits, if any, substantially depend upon the continued widespread use of the Internet as an effective medium ofbusiness and communication. Factors which could reduce the widespread use of the Internet include:•actual or perceived lack of security of information or privacy protection; •possible disruptions, computer viruses or other damage to the Internet servers or to users' computers; and •excessive governmental regulation.Customers may be unwilling to use the Internet to purchase goods. Our long-term future depends heavily upon the general public's willingness to use the Internet as a means to purchase goods. E-commerceremains a relatively new concept, and large numbers of customers may not begin or continue to use the Internet to purchase goods. The demandfor and acceptance of products sold over the Internet are highly uncertain, and most e-commerce businesses have a short track record. Ifconsumers are unwilling to use the Internet to conduct business, our business may not develop profitably.The security risks or perception of risks of e-commerce may discourage customers from purchasing goods from us. In order for the e-commerce market to develop successfully, we and other market participants must be able to transmit confidentialinformation securely over public networks. Third parties may have the technology or know-how to breach the security of customer transaction data.Any breach could cause customers to lose confidence in the security of our Websites and choose not to purchase from our Websites. If someoneis able to circumvent our security measures, he or she could destroy or steal valuable information or disrupt our operations. Concerns about thesecurity and privacy of transactions over the Internet could inhibit the growth of the Internet and e-commerce. Our security measures may noteffectively prohibit others from obtaining improper access to our information. Third parties may target our customers directly with fraudulent identitytheft schemes designed to appear as legitimate communications from us. Any security breach or fraud perpetrated on our customers could exposeus to increased costs and to risks of loss, litigation and liability and could seriously disrupt our operations.Credit card fraud could adversely affect our business. We do not carry insurance against the risk of credit card fraud, so the failure to adequately control fraudulent credit card transactions couldreduce our net revenues and our gross margin. We have implemented technology to help us detect the fraudulent use of credit card information.However, we may in the future suffer losses as a result of orders placed with fraudulent credit card data even though the associated financialinstitution approved payment of the orders. Under current credit card practices,24 we may be liable for fraudulent credit card transactions because we do not obtain a cardholder's signature. If we are unable to detect or controlcredit card fraud, our liability for these transactions could harm our business, results of operation or financial condition.If one or more states successfully assert that we should collect sales or other taxes on the sale of our merchandise or the merchandiseof third parties that we offer for sale on our Websites, our business could be harmed. We do not currently collect sales or other similar taxes for physical shipments of goods into states other than Utah or Indiana. One or morelocal, state or foreign jurisdictions may seek to impose sales tax collection obligations on us and other out-of-state companies that engage inonline commerce. Our business could be adversely affected if one or more states or any foreign country successfully asserts that we shouldcollect sales or other taxes on the sale of our merchandise.Existing or future government regulation could harm our business. We are subject to the same federal, state and local laws as other companies conducting business on the Internet. Today there are relativelyfew laws specifically directed towards conducting business on the Internet. However, due to the increasing popularity and use of the Internet,many laws and regulations relating to the Internet are being debated at the state and federal levels. These laws and regulations could cover issuessuch as user privacy, freedom of expression, pricing, fraud, quality of products and services, taxation, advertising, intellectual property rights andinformation security. Applicability to the Internet of existing laws governing issues such as property ownership, copyrights and other intellectualproperty issues, taxation, libel, obscenity and personal privacy could also harm our business. For example, United States and foreign lawsregulate our ability to use customer information and to develop, buy and sell mailing lists. The vast majority of these laws was adopted prior to theadvent of the Internet, and do not contemplate or address the unique issues raised thereby. Those laws that do reference the Internet, such as theDigital Millennium Copyright Act and the CAN-SPAM Act of 2003, are only beginning to be interpreted by the courts and their applicability andreach are therefore uncertain. These current and future laws and regulations could harm our business, results of operation and financial condition.Laws or regulations relating to privacy and data protection may adversely affect the growth of our Internet business or our marketingefforts. We are subject to increasing regulation at the federal, state and international levels relating to privacy and the use of personal userinformation. For example, we are subject to various telemarketing laws that regulate the manner in which we may solicit future suppliers andcustomers. Such regulations, along with increased governmental or private enforcement, may increase the cost of growing our business. Inaddition, several states have proposed legislation that would limit the uses of personal user information gathered online or require online servicesto establish privacy policies. The Federal Trade Commission has adopted regulations regarding the collection and use of personal identifyinginformation obtained from children under 13. Bills proposed in Congress would extend online privacy protections to adults. Moreover, proposedlegislation in this country and existing laws in foreign countries require companies to establish procedures to notify users of privacy and securitypolicies, obtain consent from users for collection and use of personal information, and/or provide users with the ability to access, correct anddelete personal information stored by us. We could become a party to a similar enforcement proceeding. These data protection regulations andenforcement efforts may restrict our ability to collect demographic and personal information from users, which could be costly or harm ourmarketing efforts.25 Risks Relating to the Securities Markets and Ownership of Our SecuritiesThe price of our securities may be volatile and you may lose all or a part of your investment. Our common stock has been publicly traded only since May 30, 2002. The market price of our common stock has been subject to significantfluctuations since the date of our initial public offering. These fluctuations could continue. It is possible that in some future periods our results ofoperations may be below the expectations of public market analysts and investors. If this occurs, the market price of our securities may decline.Among the factors that could affect the market price of our securities are as follows:•changes in securities analysts' recommendations or estimates of our financial performance or publication of research reports byanalysts; •changes in market valuations of similar companies; •announcements by us or our competitors of significant contracts, acquisitions, commercial relationships, joint ventures or capitalcommitments; •general market conditions; •actual or anticipated fluctuations in our operating results; •intellectual property or litigation developments; •changes in our management team; •economic factors unrelated to our performance; and •our issuance of additional shares of stock or other securities. In addition, the securities markets have experienced significant price and trading volume fluctuations. These broad market fluctuations mayadversely affect the trading price of our securities. In the past, following periods of volatility in the market price of a public company's securities,securities class action litigation has often been instituted against that company. Such litigation could result in substantial cost and a diversion ofmanagement's attention and resources.Our quarterly operating results are volatile and may adversely affect the market price of our securities. Our future revenues and operating results are likely to vary significantly from quarter to quarter due to a number of factors, many of which areoutside our control, and any of which could harm our business. As a result, we believe that quarterly comparisons of our operating results are notnecessarily meaningful and that you should not rely on the results of one quarter as an indication of our future performance. In addition to the otherrisk factors described in this report, additional factors that have caused and/or could cause our quarterly operating results to fluctuate and in turnaffect the market price of our securities include:•increases in the cost of advertising; •our inability to retain existing customers or encourage repeat purchases; •the extent to which our existing and future marketing agreements are successful; •price competition that results in lower profit margins or losses; •the amount and timing of operating costs and capital expenditures relating to the expansion of our business operations andinfrastructure; •the amount and timing of our purchases of inventory;26 •our inability to manage distribution operations or provide adequate levels of customer service; •our ability to successfully integrate operations and technologies from acquisitions or other business combinations; •entering into new lines of products; •our ability to attract users to our new auctions site; and •our inability to replace the loss of significant customers.Our operating results may fluctuate depending on the season, and such fluctuations may affect the market price of our securities. We have experienced and expect to continue to experience fluctuations in our operating results because of seasonal fluctuations intraditional retail patterns. Sales in the retail and wholesale industry tend to be significantly higher in the fourth calendar quarter of each year than inthe preceding three quarters due primarily to increased shopping activity during the holiday season. However, there can be no assurance that oursales in the fourth quarter will exceed those of the preceding quarters or, if the fourth quarter sales do exceed those of the preceding quarters, thatwe will be able to manage the increased sales effectively. Further, we generally increase our inventories substantially in anticipation of holidayseason shopping activity, which has a negative effect on our cash flow. Securities analysts and investors may inaccurately estimate the effects ofseasonality on our results of operations in one or more future quarters and, consequently, our operating results may fall below expectations,causing the market price of our securities to decline.We do not intend to pay dividends on our non-redeemable common stock, and you may lose the entire amount of your investment in ourcommon stock. We have never declared or paid any cash dividends on our non-redeemable common stock and do not intend to pay dividends on our non-redeemable common stock for the foreseeable future. We intend to invest our future earnings, if any, to fund our growth. Therefore, you will notreceive any funds without selling your shares. We cannot assure that you will receive a positive return on your investment when you sell yourshares or that you will not lose the entire amount of your investment.Our Amended and Restated Certificate of Incorporation, Amended and Restated Bylaws and the Delaware General Corporation Lawcontain anti-takeover provisions which could discourage or prevent a takeover, even if an acquisition would be beneficial to ourstockholders. Several provisions of our Amended and Restated Certificate of Incorporation and Amended and Restated Bylaws could discourage potentialacquisition proposals and could delay or prevent a change in control of our company even if that change in control would be beneficial to ourstockholders. For example, only one-third of our board of directors will be elected at each of our annual meetings of stockholders, which will makeit more difficult for a potential acquirer to change the management of our company, even after acquiring a majority of the shares of our commonstock. These provisions, which cannot be amended without the approval of two-thirds of our stockholders, could diminish the opportunities for astockholder to participate in tender offers, including tender offers at a price above the then current market value of our common stock. In addition,our board of directors, without further stockholder approval, may issue preferred stock, with such terms as the board of directors may determine,that could have the effect of delaying or preventing a change in control of our company. The issuance of preferred stock could also adverselyaffect the voting powers of the holders of common stock, including the loss of voting control to others. We are also afforded the protections ofSection 203 of the Delaware General Corporation Law, which could delay or prevent a change in control of our company or could impede a merger,consolidation, takeover or other business combination involving our company or discourage a potential acquirer from making a tender offer orotherwise attempting to obtain control of our company.27 Available Information Our Internet website address is http://www.overstock.com. Our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, CurrentReports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934are available free of charge through our Internet website as soon as reasonably practicable after we electronically file such material with, or furnishit to, the SEC. Our Internet website and the information contained therein or connected thereto are not intended to be incorporated into this AnnualReport on Form 10-K. ITEM 2. PROPERTIES We lease approximately 43,000 square feet of office space for our corporate headquarters and customer service operations in Salt Lake City,Utah, and we lease an approximately 354,000 square foot warehouse and distribution facility also in Salt Lake City, Utah. We also lease space in aco-location facility which houses our primary computer infrastructure, and we utilize a third party logistics center located in Plainfield, Indiana. InDecember 2004 we entered into an agreement to lease approximately 143,000 square feet of office space for our corporate headquarters andcustomer service operations in Salt Lake City and intend to move from our current headquarters into the new facility in the summer of 2005. Webelieve that these facilities will be sufficient for our needs for the next twelve months. ITEM 3. LEGAL PROCEEDINGS From time to time, we receive claims of and become subject to consumer protection, employment, intellectual property and other commerciallitigation related to the conduct of our business. Such litigation could be costly and time consuming and could divert our management and keypersonnel from our business operations. The uncertainty of litigation increases these risks. In connection with such litigation, we may be subject tosignificant damages or equitable remedies relating to the operation of our business and the sale of products on our websites. Any such litigationmay materially harm our business, prospects, results of operations, financial condition and cash flows. However, we do not currently believe thatany of our outstanding litigation will have a material impact on our financial statements. In October 2003, Tiffany (NJ) Inc. and Tiffany and Company filed a complaint against us in the United States District Court for the SouthernDistrict of New York alleging that we have distributed counterfeit and otherwise unauthorized Tiffany product in violation of federal copyright andtrademark law and related state laws. The complaint seeks statutory and other damages in an unspecified amount and injunctive relief. InJanuary 2005, Tiffany (NJ) Inc. and Tiffany and Company filed four additional complaints against us in the United States District Court for theSouthern District of New York alleging that we have distributed counterfeit and otherwise unauthorized Tiffany product in violation of federalcopyright and trademark law and related state laws. These complaints also seek statutory and other damages in an unspecified amount andinjunctive relief. Although we have filed answers to these complaints and we believe we have defenses to the allegations and intend to pursuethem vigorously, we do not have sufficient information to assess the validity of the claims or the amount of potential damages alleged in thesesuits. In July 2004, Printmaker International, Ltd. filed a complaint against us in the United States District Court for the Southern District of NewYork alleging that we have distributed counterfeit and otherwise unauthorized product in violation of federal copyright and trademark law and relatedstate laws. The complaint seeks statutory and other damages in an unspecified amount and injunctive relief. Although we have filed an answer andbelieve we have defenses to the allegations and intend to pursue them vigorously, the Printmaker lawsuit is in the early stages of discovery, andwe do not have sufficient information to assess the validity of the claims or the amount of potential damages. Our28 fulfillment partner (who is also a defendant in the case) is conducting the defense of the case and has agreed to indemnify us against the claimand any judgment. In May 2004, we filed a complaint against TLMT Holdings, Inc (f/k/a LastMinuteTravel.com, Inc.) in the Superior Court of the State ofDelaware alleging that it breached its contract with us. In July 2004, TLMT Holdings filed a counterclaim against us alleging that we have breachedthe contract. The counterclaim seeks damages in an unspecified amount. We have filed an answer to the counterclaim and we believe we havedefenses to the allegations and intend to pursue them vigorously. At this point in time, we do not have sufficient information to assess the validityof the claims or the amount of potential damages. In January 2003, we received a letter from NCR Corporation claiming that certain of our business practices and information technologysystems infringe patents owned by NCR. The letter further stated that NCR would vigorously protect its intellectual property rights if we did notagree to enter into licensing arrangements with respect to the asserted patents. On January 31, 2003, we filed a complaint in the United StatesDistrict Court of Utah, Central Division, seeking declaratory judgment that we do not infringe any valid claim of the patents asserted by NCR. OnMarch 24, 2003, NCR filed an answer and counterclaims alleging that certain of our business practices and information technology systemsinfringe patents owned by NCR. On April 8, 2003, we filed an answer denying the material allegations in NCR's counterclaims. On May 12, 2003,the parties entered into a standstill agreement, agreeing to the dismissal of the complaint and counterclaims without prejudice to either party'sability to renew its claims at a later date. On May 19, 2003, the court entered an order dismissing the complaint and counterclaims withoutprejudice. The parties each reserved all claims and counterclaims. In August 2004, NCR notified us of its intent to terminate the standstillagreement. On September 2, 2004, we re-filed our complaint in the United States District Court of Utah, Central Division, seeking declaratoryjudgment that we do not infringe any valid claim of the patents asserted by NCR. On October 4, 2004, NCR filed an answer and counterclaimsalleging that certain of our business practices and information technology systems infringe patents owned by NCR. On October 12, 2004, we filedan answer denying the material allegations in NCR's counterclaims. Although we have filed an answer and believe we have defenses to theallegations and intend to pursue them vigorously, the NCR lawsuit is not yet even in the early stages of discovery, and we do not have sufficientinformation to assess the validity of the claims or the amount of potential damages. In September 2004, we received a letter from BTG International Inc. claiming that certain of our business practices and online marketinginformation technology systems infringe patents owned by BTG. On September 14, 2004, without engaging in any meaningful discussion ornegotiation with us, BTG filed a complaint in the United States District Court of Delaware alleging that certain of our business practices and onlinemarketing information technology systems infringe a single patent owned by BTG. On October 21, 2004, we filed an answer denying the materialallegations in BTG's claims. Although we have filed an answer and believe we have defenses to the allegations and intend to pursue themvigorously, the BTG lawsuit is not yet even in the early stages of discovery, and we do not have sufficient information to assess the validity of theclaims or the amount of potential damages. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of 2004.29 PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OFEQUITY SECURITIES Our common stock is traded on the Nasdaq National Market under the symbol "OSTK." Prior to May 30, 2002, there was no public market forour common stock. The following table sets forth, for the periods indicated, the high and low closing prices per share for our common stock asreported on the Nasdaq National Market since May 30, 2002. CommonStock Price High LowYear Ended December 31, 2002 Second Quarter (from May 30, 2002) $14.60 $12.25 Third Quarter 14.55 5.40 Fourth Quarter 15.43 4.41Year Ended December 31, 2003 First Quarter 18.11 9.74 Second Quarter 14.69 8.00 Third Quarter 17.24 10.47 Fourth Quarter 20.92 12.84Year Ended December 31, 2004 First Quarter 34.84 16.32 Second Quarter 40.23 30.65 Third Quarter 38.27 27.88 Fourth Quarter 76.05 38.43 As of December 31, 2004, there were approximately 118 holders of record of our common stock. Because many of our shares of commonstock are held by brokers and other institutions on behalf of shareholders, we are unable to estimate the total number of shareholders representedby these record holders. We have never declared or paid any cash dividends on shares of our non-redeemable common stock. We currently intend to retain ourearnings for future growth and do not anticipate paying any cash dividends in the foreseeable future. Any future determination to pay dividends willbe at the discretion of our board of directors and will depend on our results of operations, financial conditions, contractual and legal restrictions andother factors the board deems relevant. Certain offerings of our common stock may not have complied with various requirements of applicable state and securities laws. As such,certain investors in our common stock may be entitled to return their shares to us and receive back from us the full price they paid, plus interest.Although no investors have attempted to exercise a right of rescission, and although we have never declared or paid any cash dividends on sharesof common stock that may be subject to rescission, we have recorded "interest," which may be payable on these securities if the rescission rightsare exercised, as a deemed dividend in our financial statements. If an investor does attempt to exercise a right of rescission, the interestattributable to their securities would likely become payable in cash. During 2004, except as previously reported in a Quarterly Report on Form 10-Q or current Report on Form 8-K, the Company did not sell anyequity securities that were not registered under the Securities Act, except that during the fourth quarter of 2004, 29,739 shares were issued uponthe exercise of warrants in transactions exempt from the registration requirements of the Securities Act by reason of Section 4(2) of the Act.30 During the fourth quarter of 2004, there were no purchases of shares of the Company's common stock made by or on behalf of the Companyor any "affiliated purchaser" as defined in Rule 10b-18(a)(3) under the Exchange Act. In January 2005, the Company announced that its board ofdirectors had authorized a three-year stock repurchase program for up to $50 million for the purpose of mitigating dilution from outstanding options,warrants and other convertible securities. In February and March 2005, we paid $47.5 million for several purchased call options pursuant to whichwe may purchase up to 1,250,000 shares of our common stock. ITEM 6. SELECTED FINANCIAL DATA The following selected consolidated financial data as of December 31, 2003 and 2004 and for each of the three years in the period endedDecember 31, 2004, are derived from our consolidated financial statements and are included elsewhere in this Form 10-K. The consolidatedfinancial data as of December 31, 2000, 2001 and 2002 and for the years ended December 31, 2000 and 2001, are derived from consolidatedfinancial statements, but are not contained herein. The historical results do not necessarily indicate results expected for any future period. Thisinformation should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and theConsolidated Financial Statements and the related notes thereto included elsewhere in this Form 10-K. Year ended December 31, 2000 2001 2002 2003 2004 (in thousands, except per share data) Consolidated Statement of Operations Data: Revenue Direct revenue $24,656 $36,038 $79,405 $138,134 $213,210 Fulfillment partner revenue 867 3,965 12,379 100,811 281,425 Total revenue 25,523 40,003 91,784 238,945 494,635 Cost of goods sold Direct 27,431 33,497 70,686 124,302 185,390 Fulfillment partner 381 1,143 2,755 89,190 243,468 Total cost of goods sold 27,812 34,640 73,441 213,492 428,858 Gross profit (loss) (2,289) 5,363 18,343 25,453 65,777 Operating expenses: Sales and marketing expenses 11,376 5,784 8,669 20,173 40,533 General and administrative expenses 7,556 9,441 10,825 16,911 30,235 Amortization of goodwill 226 3,056 — — — Amortization of stock-based compensation — 649 2,903 756 360 Total operating expenses 19,158 18,930 22,397 37,840 71,128 Operating loss (21,447) (13,567) (4,054) (12,387) (5,351)Interest income 241 461 403 461 1,173 Interest expense (73) (729) (465) (76) (775)Other income (expense), net (33) 29 (444) 115 (49) Net loss (21,312) (13,806) (4,560) (11,887) (5,002)Deemed dividend related to redeemable common stock (210) (404) (406) (262) (188)Deemed dividend related to beneficial conversion featureof preferred stock — — (6,607) — — Net loss attributable to common shares $(21,522)$(14,210)$(11,573)$(12,149)$(5,190) Net loss per common share—basic and diluted $(3.63)$(1.29)$(0.88)$(0.75)$(0.29)Weighted average common shares outstanding—basicand diluted 5,922 10,998 13,108 16,198 17,846 31 As of December 31, 2000 2001 2002 2003 2004 (in thousands)Balance Sheet Data: Cash and cash equivalents $8,348 $3,729 $11,059 $28,846 $198,678Marketable securities — — 21,603 11,500 88,802Working capital 6,440 3,071 35,679 45,284 266,668Total assets 30,401 21,714 63,956 97,732 376,264Total indebtedness 3,591 4,677 182 161 117,589Redeemable common stock 4,930 5,284 4,363 2,978 3,166Stockholders' equity 12,349 5,980 39,271 54,914 168,532 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION The following Management's Discussion and Analysis of Financial Condition and Results of Operation should be read in conjunction with ourConsolidated Financial Statements and the related Notes thereto. This discussion contains forward-looking statements based upon currentexpectations that involve risks and uncertainties, such as our plans, objectives, expectations and intentions, as set forth under "Special NoteRegarding Forward-Looking Statements." Our actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of several factors, including those set forth in the following discussion and under "Risk Factors" and elsewhere inthis Form 10-K.Overview We are an online "closeout" retailer offering discount brand name merchandise, including bed-and-bath goods, furniture, kitchenware,watches, jewelry, computers and electronics, sporting goods, apparel and designer accessories and travel. Our company, based in Salt Lake City,Utah, was founded in 1997, and we launched our first Website through which customers could purchase products in March 1999. Our revenue is comprised of direct revenue and fulfillment partner revenue. Direct revenue includes sales made to individual consumers andbusinesses, which are fulfilled from our warehouse in Salt Lake City, Utah or our outsourced warehouse located in Plainfield, Indiana, and salesfrom our warehouse store which we closed in January 2004. Customers place orders through our main website, www.overstock.com. Although wehistorically operated a separate business-to-business ("B2B") Website, our direct revenue has predominantly been based on purchases madedirectly through our main consumer Website. As a result, during the third quarter of 2004, we integrated the B2B Website into our consumerWebsite, and B2B clients now buy products primarily through our Club O frequent buyers club and our Club O Gold bulk purchase program. During 2003, Safeway, Inc. accounted for approximately 9% of our total revenue. However, our relationship with Safeway terminated inFebruary 2004. During 2004, no single customer accounted for more than 1% of our total revenue. Our fulfillment partner revenue is generated when we sell merchandise of other retailers, cataloguers or manufacturers ("fulfillment partners")through our Website. Prior to July 1, 2003, we did not own or physically handle the merchandise we sold in these transactions, as the merchandisewas shipped directly by a third party vendor, which also handled all customer returns related to those sales. Beginning July 1, 2003, we tookresponsibility for returned items relating to these sales and we now handle the resale of returned items. As a result, beginning July 1, 2003, we areconsidered to be the primary obligor for the majority of these sales transactions, and we assume the risk of loss on returned items. As aconsequence, we now record revenue from the majority of these sales transactions involving our fulfillment partners (excluding auction and travelproducts) on a gross basis, rather than on a net basis as we did prior to July 1, 2003. Similar to our direct segment, fulfillment partner products are32 available to both consumers and businesses through our Club O frequent buyers club initiative and our Club O Gold bulk purchase initiative. Ouruse of the term "partner" or "fulfillment partner" does not mean that we have formed any legal partnerships with any of our fulfillment partners. During September 2004, we added an online auction service to our Website. Our auction service allows sellers to list items for sale, buyersto bid on items of interest, and users to browse through listed items online. We are not the seller of the items sold on the auction site and we haveno control over the pricing of those items. Therefore, for auctions, we record only our listing fees for items listed and commissions for items soldas revenue. Unless otherwise indicated or required by the context, the discussion herein of our financial statements, accounting policies andrelated matters pertains to our shopping site and not necessarily to our auction site. Revenue from our auctions business is included in thefulfillment partner segment in 2004, as it is not material. During the first quarter of 2005, we reopened our discount travel store to our Website, currently offering cruise packages. In the future, weintend to offer other travel products such as flight, hotel, and rental car reservations. For the products or services that we sell in our travel store,we do not currently have inventory risk or pricing control, and do not directly provide customer service. Therefore, for these sales we are notconsidered to be the primary obligor, and record only our commission as revenue. Our revenue is recorded net of returns, coupons and other discounts. Subject to some limitations, our returns policy for products other thanthose sold in our Electronics and Computers department provides for a $4.95 restocking fee and the provision that we will not accept productreturns initiated more than 20 days after the shipment date. We charge a 15% restocking fee (instead of the $4.95 restocking fee) on itemsreturned for non-defective reasons from the Electronics and Computers department. Cost of goods sold consists of the cost of the product, as well as inbound and outbound freight and fulfillment costs. Fulfillment costsinclude warehouse handling labor costs, fixed warehouse costs, credit card fees and customer service costs. Fulfillment costs represented 10%,8% and 7% of total revenue for the years ended December 31, 2002, 2003 and 2004, respectively, as noted in the following table (in thousands): Year ended December 31, 2002 2003 2004 Total revenue $91,784 100%$238,945 100%$494,635 100%Cost of goods sold Product costs and other cost of goods sold 64,068 70% 193,190 81% 394,580 80% Fulfillment costs 9,373 10% 20,302 8% 34,278 7% Total cost of goods sold 73,441 80% 213,492 89% 428,858 87% Gross profit $18,343 20%$25,453 11%$65,777 13% This table has been included to provide investors additional information regarding our classification of fulfillment costs and gross margins,thus enabling investors to better compare our fulfillment costs and gross margins with others in our industry. We believe that some companies inour industry, including some of our competitors, account for fulfillment costs within operating expenses, and therefore exclude fulfillment costsfrom gross margins. As a result, our gross margins may not be directly comparable to others in our industry. Our gross margins on sales through our Club O frequent buyers club, our Club O Gold bulk purchases program and our BMV products tend tobe lower than margins on our other sales, and our33 overall gross margins will be impacted by the blend of Club O, Club O Gold, and BMV sales as a percentage of our total revenue. Sales and marketing expenses consist primarily of advertising, public relations and promotional expenditures, as well as payroll and relatedexpenses for personnel engaged in marketing and selling activities. Advertising expense is the largest component of our sales and marketingexpenses and is primarily attributable to expenditures related to online marketing activities and our offline national radio and television advertising.For the years ended December 31, 2002, 2003 and 2004, our advertising expenses totaled approximately $7.0 million, $18.6 million and$39.2 million, which represents 81%, 92% and 97%, respectively, of our sales and marketing expenses. We expect our sales and marketingexpenses to increase in future periods on an absolute dollar basis as we expect to continue to increase our advertising in our efforts to continue togrow the business. General and administrative expenses consist of wages and benefits for executive, accounting, technology, merchandising and administrativepersonnel, rents and utilities, legal and accounting fees, travel and entertainment, depreciation and amortization and other general corporateexpenses. We adopted SFAS No. 142 for the fiscal year beginning January 1, 2002. Under this pronouncement, any remaining goodwill is not amortized,but is evaluated at least annually for impairment. There were no impairments of goodwill during the years ended December 31, 2002, 2003 and2004. We have recorded no provision or benefit for federal and state income taxes as we have incurred net operating losses since inception. As ofDecember 31, 2003 and 2004, we had net operating loss carryforwards of approximately $48.0 million and $53.3 million, respectively, which maybe used to offset future taxable income. An additional $14.4 million of net operating losses are limited under Internal Revenue Code Section 382 to$799,000 a year. These carryforwards begin to expire in 2019. We have provided a full valuation allowance on the deferred tax asset, consistingprimarily of net operating loss carryforwards, because of uncertainty regarding its realizability. Both direct and fulfillment partner revenue are seasonal, with revenues historically being the highest in the fourth quarter, reflecting higherconsumer holiday spending. We anticipate this will continue in the foreseeable future. With the exception of our acquisition of Gear.com, we haveachieved our historical growth from internal operations.Executive Commentary This executive commentary is intended as a supplement to, but not a substitute for, the more detailed discussion of our business includedelsewhere herein. Investors are cautioned to read our entire Management's Discussion and Analysis of Financial Condition and Results ofOperation, as well as our audited financial statements, and the discussion of our business and risk factors and other information includedelsewhere in this report. This executive commentary includes forward-looking statements, and investors are cautioned to read the Special NoteRegarding Forward-Looking Statements included elsewhere in this report. Commentary—Increases in Gross Bookings. Management believes that to understand our business and our financial statements, investorsshould understand the difference between total revenue and gross bookings. Gross bookings represents the gross selling price of all transactions,including those for which we only record a commission, before returns, sales discounts, and before payments to fulfillment partners prior to July 1,2003, and therefore differs from total revenue. We sustained year-over-year growth in gross bookings for 2004's four quarters of 79%, 88%, 87%,and 82%, respectively, compared to 2003's respective quarters. For the year, gross bookings grew 84% from $294.8 million to $541.4 million in2004. Our B2C business, which excludes Safeway and our B2B business, grew 106% in 2004. This growth was due to the continued expansion ofour customer base (2.5 of our 5.5 million34 customers were added during 2004) from our online and offline marketing efforts. We consider the growth in gross bookings especially noteworthy,because we ended our arrangement with Safeway in February 2004. The Safeway program had represented 10% of gross bookings during 2003,and less than 1% of gross bookings in 2004. Commentary—Improved gross margins. Quarterly gross margins during the periods Q4 2003 through Q4 2004 were: 9.6%, 10.3%, 11.3%,13.3% and 15.2%, respectively. In comparing 2003 and 2004, revenue increased 107% (from $238.9 million to $494.6 million) while gross profitdollars increased 158% (from $25.5 million to $65.8 million). Management considers improvements in gross margins and the resulting increase ingross profit dollars to be an important aspect of our financial results. The improvements in gross margins are a result of improvements made or efficiencies gained in several areas. In particular, we believe thatour buying has become more effective as we continue to grow, allowing us to make larger inventory purchases and obtain more favorable pricing.Our handling cost per package has decreased during the year due to better process management and lower packaging costs from increased salesvolumes. As a result of increased volumes and improved vendor relationships, we have obtained decreases in both inbound and outbound shippingcosts. We have also made improvements to the cost of processing returns, customer service costs and credit card fees. Commentary—Marketing efforts. For 2004, our sales and marketing expenses increased 101% from $20.2 million in 2003 to $40.5 millionin 2004. Our average customer acquisition cost ("CPA") for 2004 increased to $16.43, an increase of 36% over the $12.09 we achieved in 2003.This increase in CPA is partially a result of increased pricing of on-line marketing in general, as well an increase in overall marketing expendituresin an effort to strengthen our brand. In addition, in the fourth quarter of 2004, we spent approximately $1.6 million marketing our new auctionsbusiness, which increased our overall marketing expenditures and reduced our return on our marketing investment. Commentary—Expense Control. G&A increased 79% in absolute dollars, from $16.9 million in 2003 to $30.2 million in 2004, but as apercentage of gross bookings, G&A remained constant at 6%. Increases to G&A are a result of higher payroll costs from additional corporatestaffing, as well as increased technology, legal, accounting and other corporate costs. Commentary—Inventory. During the third and fourth quarters we increased our inventory in preparation for the 2004 holiday season. Webelieve that we ended 2004 with appropriate inventory levels for the first quarter of 2005. Commentary—Strategic Projects. Following is a brief update on some of our recent strategic projects and initiatives:1)Auctions—We launched our auctions business in September 2004. 2)Travel—In January 2005 we added cruise offerings to our website. We intend to add additional travel services in the future. 3)Design Your Own Jewelry™—In January 2005, we launched a new category within our jewelry store—Design Your Own Jewelry. Thiscategory allows customers purchasing diamond rings to select both a specific diamond and ring setting. In August 2004, we entered into anagreement with an entity which allows us to lend up to $10.0 million to the entity for the purpose of buying inventory, primarily to supply thisnew category. In November 2004, we loaned the entity $8.4 million for this purpose (See Note 20 to the consolidated financial statementsfor additional information regarding this transaction).35 The balance of our Management's Discussion and Analysis of Financial Condition and Results of Operation provides further information aboutthe matters discussed above and other important matters affecting our business.Critical Accounting Policies and Estimates Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United Statesof America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts ofassets, liabilities, revenues and expenses. We base our estimates on historical experience and on various other assumptions that we believe to bereasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilitiesthat are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Ourcritical accounting policies are as follows:•revenue recognition; •estimating valuation allowances and accrued liabilities, specifically, the reserve for returns, the allowance for doubtful accounts andthe allowance for obsolete and damaged inventory; •accounting for income taxes; and •valuation of long-lived and intangible assets and goodwill. Revenue recognition. We derive our revenue from three sources: (i) direct revenue, which consists of merchandise sales made toconsumers and businesses that are fulfilled from our warehouse; (ii) fulfillment partner revenue, which consists of revenue from the sale ofmerchandise shipped by fulfillment partners directly to consumers and other businesses, as well as fee revenue collected from the products listedand sold through the auction tab of our Website; and (iii) commission revenue from our auctions and travel operations. All sources of revenue arerecorded net of returns, coupons redeemed by customers, and other discounts. Revenue from our auction and travel services were not material in2004 and therefore are included in fulfillment partner revenue. Prior to July 1, 2003, we did not own or physically handle the merchandise sold in fulfillment partner transactions, as the merchandise wasshipped directly by a third party vendor, who also handled all customer returns related to those sales. However, beginning July 1, 2003, we tookresponsibility for returned items relating to these sales, and we now handle the resale of returned items. As a result, beginning July 1, 2003, we areconsidered to be the primary obligor for the majority of these sales transactions, and we assume the risk of loss on returned items. As aconsequence, we now record revenue from the majority of these sales transactions involving our fulfillment partners (excluding auction and travelproducts) on a gross basis, rather than recording them on a net basis as we did prior to July 1, 2003. Similar to our direct revenue segment,fulfillment partner products are available to both consumers and businesses through our Club O frequent buyers club and our Club O Gold bulkpurchase program. For sales transactions, we comply with the provisions of Staff Accounting Bulletin 104 "Revenue Recognition", which states that revenueshould be recognized when the following revenue recognition criteria are met: (1) persuasive evidence of an arrangement exists; (2) the producthas been shipped or the service provided and the customer takes ownership and assumes the risk of loss; (3) the selling price is fixed ordeterminable; and (4) collection of the resulting receivable is reasonably assured. We generally require payment by credit card at the point of sale.Amounts received prior to when we ship the goods or provide the services to customers are recorded as deferred revenue. In addition, amountsreceived in advance for Club O and Club O Gold membership fees are recorded as deferred revenue and recognized over the membership period.36 Reserve for returns, allowance for doubtful accounts and the allowance for obsolete and damaged inventory. Our management must makeestimates of potential future product returns related to current period revenue. Management analyzes historical returns, current economic trendsand changes in customer demand and acceptance of our products when evaluating the adequacy of the sales returns reserve and otherallowances in any accounting period. The reserve for returns was $1.1 million as of December 31, 2003 and $2.8 million as of December 31, 2004. From time to time, we may grant credit to certain of our business customers on normal credit terms. We perform ongoing credit evaluationsof our customers' financial condition and maintain an allowance for doubtful accounts receivable based upon our historical collection experienceand expected collectibility of all accounts receivable. We maintained an allowance for doubtful accounts receivable of $650,000 as ofDecember 31, 2003 and $750,000 as of December 31, 2004. We write down our inventory for estimated obsolescence or damage equal to the difference between the cost of inventory and the estimatedmarket value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than thoseprojected by management, additional inventory write-downs may be required. Our inventory balance was $29.9 million, net of reserve forobsolescence or damaged inventory of $1.1 million as of December 31, 2003. At December 31, 2004, our inventory balance was $45.3 million, netof reserve for obsolescence or damaged inventory of $1.3 million. Accounting for income taxes. Significant management judgment is required in determining our provision for income taxes, our deferred taxassets and liabilities and any valuation allowance recorded against our net deferred tax assets. As of December 31, 2003 and 2004, we haverecorded a full valuation allowance of $25.7 million and $28.5 million, respectively, against our net deferred tax asset balance due to uncertaintiesrelated to our deferred tax assets as a result of our history of operating losses. The valuation allowance is based on our estimates of taxableincome by jurisdiction in which we operate and the period over which our deferred tax assets will be recoverable. In the event that actual resultsdiffer from these estimates or we adjust these estimates in future periods, we may need to change the valuation allowance, which could materiallyimpact our financial position and results of operations. Valuation of long-lived and intangible assets and goodwill. Under SFAS 142, Goodwill and Other Intangible Assets, goodwill is no longeramortized, but must be tested for impairment at least annually. Other long-lived assets must also be evaluated for impairment when managementbelieves that an asset has experienced a decline in value that is other than temporary. Future adverse changes in market conditions or pooroperating results of underlying investments could result in losses or an inability to recover the carrying value of the asset that may not be reflectedin an asset's current carrying value, thereby possibly requiring an impairment charge in the future. There were no impairments of goodwill or long-lived assets during 2003 or 2004. Goodwill amounted to $2.8 million as of December 31, 2003 and 2004.37 Results of Operations The following table sets forth our results of operations expressed as a percentage of total revenue for 2002, 2003 and 2004. Year ended December 31, 2002 2003 2004 (as a percentage oftotal revenue) Revenue Direct revenue 86.5%57.8%43.1% Fulfillment partner revenue 13.5 42.2 56.9 Total revenue 100.0 100.0 100.0 Cost of goods sold Direct 77.0 52.0 37.5 Fulfillment partner 3.0 37.3 49.2 Total cost of goods sold 80.0 89.3 86.7 Gross profit 20.0 10.7 13.3 Operating expenses: Sales and marketing expenses 9.4 8.4 8.2 General and administrative expenses 11.8 7.1 6.1 Amortization of stock-based compensation 3.2 0.3 0.1 Total operating expenses 24.4 15.8 14.4 Operating loss (4.4)(5.1)(1.1)Interest income 0.4 0.2 0.2 Interest expense (0.5)(0.0)(0.1)Other income (expense), net (0.5)0.0 0.0 Net loss (5.0)%(4.9)%(1.0)% Comparison of Years Ended December 31, 2003 and 2004Revenue Beginning July 1, 2003, customer returns from sales shipped by our fulfillment partners are returned directly to us and processed through ourSalt Lake City warehouse, rather than returned to our fulfillment partners, as they previously were. We made the decision to change this policy tohave more control over the Overstock customer shopping experience, as we believe that a seamless customer experience is key to creating loyal,long-term customers. By accepting returns at our warehouse, we can verify that fulfillment partner products are being packaged and shipped to ourstandards. Additionally, as customer returns are now all shipped to one location, the process is simpler and more convenient for our customers. As a result of this change in business practices, we now record the majority of these sales transactions shipped by our fulfillment partners ona gross basis instead of a net basis as we have historically done. Therefore, from the third quarter 2003 forward, revenue recorded in accordancewith accounting principles generally accepted in the United States ("GAAP") will increase significantly from our results as reported in SEC filingsprior to the third quarter of 2003. Additionally, direct revenue, as a percentage of total revenue will decrease significantly while fulfillment partnerrevenue, as a percentage of total revenue, will increase significantly. As a result, for each of the years presented, we believe that for year-over-year comparison purposes, gross bookings comparisons may be more38 informative than revenue comparisons, as the gross bookings were not affected by the change in business practices. Gross bookings representsthe gross selling price of all transactions before returns, sales discounts, and before payments to fulfillment partners prior to July 1, 2003. Since ithas been over 12 months since we implemented the change described above, year-over-year revenue, in addition to gross bookings, will again becomparable in 2005. Total revenue grew from $238.9 million in 2003, to $494.6 million in 2004, representing growth of 107%. During this same period, directrevenue increased from $138.1 million to $213.2 million (54% growth) and fulfillment partner revenue grew from $100.8 million to $281.4 million(179% growth). The significant increase in total revenue was due primarily to the change in our business practices described above, coupled withan increase in the number of orders (including both direct and fulfillment partner orders), which grew from 3.1 million in 2003 to 5.8 million in 2004. Our total revenue continues to expand from increased marketing efforts, including new nationwide television commercials and radioadvertising campaigns. The increase in total revenue is a reflection of our ability to acquire new customers, as evidenced by our addition of2.5 million new customers in 2004. Gross bookings totaled $294.8 million and $541.4 million for the years ended December 31, 2003 and 2004, respectively, representing anincrease of 84%. Gross bookings differ from GAAP revenue in that gross bookings represent the gross sales price of goods sold by the Companybefore returns, sales discounts and before payments to fulfillment partners prior to July 1, 2003.Cost of Goods Sold and Gross Margins As a result of the fulfillment partner returns policy change that occurred beginning the third quarter of 2003, we now record sales transactionsshipped by our fulfillment partners on a gross basis instead of on a net basis as we have historically done. Therefore, cost of goods sold increasedsignificantly beginning in the third quarter of 2003, which resulted in a decrease in gross margins from previous quarters. These margins will nowmore closely resemble margins we receive from our direct revenue. As a result, we believe that for year-over-year comparison purposes, grossprofit dollar comparisons may be more informative than gross margin percentage comparisons. Since it has been over 12 months since weimplemented the change described above, year-over-year results will again be comparable in 2005. Cost of goods sold increased in absolute dollars, from $213.5 million in 2003 to $428.9 million in 2004. In comparing 2003 and 2004, totalrevenue increased 107% (from $238.9 million to $494.6 million) while gross profit dollars increased 158% (from $25.5 million to $65.8 million).However, as a percent of total revenue, cost of goods sold decreased from 89% to 87% for those respective periods resulting in gross margins of11% and 13% for the years ended December 31, 2003 and 2004, respectively. Quarterly gross margins during the periods from the fourth quarterof 2003 through the fourth quarter of 2004 were: 9.6%, 10.3%, 11.3%, 13.3% and 15.2%, respectively. The improvements in gross margins are aresult of the progress we achieved and efficiencies gained in several areas. In particular, we believe our buying has become more effective as wecontinue to grow, allowing us to make larger inventory purchases and obtain more favorable pricing. Our handling cost/package has decreasedduring the year due to better process management and lower packaging costs from increased sales volumes. Fulfillment costs in 2003 and 2004were $20.3 million and $34.3 million, respectively, representing 8% and 7% of total revenue, respectively. As a result of increased volumes andimproved vendor relationships, we have obtained decreases in both inbound and outbound shipping costs. Additionally, we have also madeimprovements to the cost of processing returns, customer service costs and credit card fees. Gross profits for our direct operations increased from $13.8 million for the year ended December 31, 2003 to $27.8 million recorded during thesame period in 2004. For our direct39 operations, gross profit dollars increased 101% on a year-over-year basis while sales increased 54%. Gross profits for our direct operations, as apercentage of direct revenue increased from 10% in 2003 to 13% in 2004. This was primarily due to the efficiencies received including morefavorable pricing and effective buying as well as decreases in outbound and inbound shipping costs. Cost of goods sold on sales transactions from our fulfillment partners now includes the cost of the product, warehousing and fulfillmentcosts, including credit card fees and customer service costs. Therefore, beginning in the third quarter of 2003, overall blended gross margins aresignificantly lower than they had historically been. Our fulfillment partner operations generated gross profits of $11.6 million (12% margins) and $38.0 million (13% margins) for the years endedDecember 31, 2003 and 2004, respectively. The increase in the gross profit dollars for our fulfillment partner operations was due to the generalgrowth of the consumer business during the year, and an increase in the number of fulfillment partner products offered on our Websites. Theincrease in gross margins for our fulfillment partner operations is largely due to improvements in buying, customer service costs and credit cardfees, as well as a decrease in BMV sales from 38% of fulfillment partner revenue in 2003 to 22% in 2004. Gross margins for BMV products havehistorically been much lower than those of other product categories.Operating Expenses Sales and marketing. Sales and marketing expenses totaled $20.2 million and $40.5 million for the years ended December 31, 2003 and2004, respectively, representing 8% of total revenue for each year. During 2004, online marketing rates generally increased. This increase coupledwith our decision to increase our ongoing online marketing efforts, particularly with the large portals (MSN, Yahoo & AOL), and keyword search(Google) resulted in the increase in our sales and marketing expenses. In addition, we continued our television and radio campaigns throughout2004. General and administrative. General and administrative expenses increased from $16.9 million in 2003 to $30.2 million in 2004,representing 7% and 6% of total revenue, respectively. As a percentage of gross bookings, general and administrative expenses were 6% for eachof those respective years. The increase in absolute dollars was primarily attributable to costs associated with building infrastructure, includingexpansion of corporate systems and additional personnel costs from increased corporate headcount. The increase in general and administrativeexpenses also included the costs associated with the strategic projects of 2004, namely, completion our auctions tab, reconstruction of our traveldepartment and the development of our search engine. The 2004 increase also reflects significant increases in technology, legal and accountingcosts over 2003. Amortization of stock-based compensation. Prior to the Company's initial public offering in May 2002, the Company recorded unearnedstock-based compensation related to stock options granted below the fair market value of the underlying stock. Since the initial public offering, theCompany has not granted any additional stock options below fair market value. Amortization of stock-based compensation was approximately$756,000 and $360,000 for the years ended December 31, 2003 and 2004, respectively. Interest income, interest expense and other income (expense). The increase in interest income from $461,000 in 2003 to $1.2 million in2004 is due to the increase in our cash and marketable securities from our equity and debt offerings during 2004. Interest expense increased from$76,000 in 2003 to $775,000 in 2004, primarily as a result of the interest expense from our convertible senior notes issued in November 2004.Other income (expense) was relatively consistent, changing from income of $115,000 in 2003 to expense of $49,000 in 2004. Income taxes. At December 31, 2003 and 2004, we had net operating loss carryforwards of approximately $48.0 million and $53.3 million,respectively, which may be used to offset future taxable40 income. An additional $14.4 million of net operating losses are limited under Internal Revenue Code Section 382 to $799,000 a year. Thesecarryforwards begin to expire in 2019.Comparison of Years Ended December 31, 2002 and 2003Revenue As previously described, beginning July 1, 2003, customer returns from sales shipped by our fulfillment partners are returned directly to usand processed through our Salt Lake City warehouse, rather than returned to our fulfillment partners. As a result of this change in businesspractices, we now record sales transactions shipped by our fulfillment partners on a gross basis instead of on a net basis. Therefore, from the thirdquarter 2003 forward, revenue recorded in accordance with accounting principles generally accepted in the United States ("GAAP") will increasesignificantly from our results as reported in previous SEC filings. Additionally, as illustrated in the table above that sets forth our results ofoperations expressed as a percentage of total revenue, direct revenue as a percentage of total revenue decreased significantly while fulfillmentpartner revenue as a percentage of total revenue increased. As a result, we believe that for year-over-year comparison purposes, gross bookings(non-GAAP) comparisons may be more informative than GAAP revenue comparisons, as gross bookings were not affected by the change inbusiness practices. Total revenue grew from $91.8 million in 2002, to $238.9 million in 2003, representing growth of 160%. During this same period, directrevenue increased from $79.4 million to $138.1 million, or 74% growth, and fulfillment partner revenue grew from $12.4 million to $100.8 million,representing growth of 714%. The significant increase in total revenue was due primarily to the change in our business practices described above,coupled with an increase in the number of both direct and fulfillment partner orders and sales to other businesses. This increase was also a resultof the growth of our B2C business due to increased marketing efforts, including the initiation of a nationwide television and radio advertisingcampaign that began in the third quarter of 2003 and continued through the fourth quarter. Gross bookings totaled $294.8 million and $154.5 millionfor the years ended December 31, 2003 and 2002, respectively, representing an increase of 91%. Gross bookings differ from GAAP revenue inthat gross bookings represent the gross sales price of goods sold by the Company before returns, sales discounts and before payments tofulfillment partners prior to July 1, 2003.Cost of Goods Sold and Gross Margins As a result of the fulfillment partner returns policy change that occurred beginning the third quarter of 2003, we now record sales transactionsshipped by our fulfillment partners on a gross basis instead of on a net basis as we have historically done. Therefore, GAAP revenue increasedsignificantly beginning in the third quarter of 2003, which resulted in a significant increase in cost of goods sold and hence, a decrease in grossmargins from previous quarters. These margins will now more closely resemble margins we receive from our direct revenue. As a result, webelieve that for year-over-year comparison purposes, gross profit dollar comparisons may be more informative than gross margin percentagecomparisons. Cost of goods sold increased in absolute dollars, from $73.4 million in 2002 to $213.5 million in 2003, and as a percent of total revenue, from80% to 89%, respectively. This increase in cost of goods sold, as a percent of total revenue, was primarily a result of the change in our businesspractices described above. In addition, cost of goods sold increased as a percentage of total revenue due to the growth in sales of BMV products,which account for approximately 12% of total revenue in 2003, compared to less than 1% in 2002. These combined changes correlate to grossmargins of 20% and 11% for the years ended December 31, 2002 and 2003, respectively. Cost of goods sold also includes stock-basedcompensation of $373,000 and $90,000 for the years ended December 31, 2002 and 2003, respectively.41 Gross profits for our direct operations increased to $13.8 million for the year ended December 31, 2003, from $8.7 million recorded during thesame period in 2002. For our direct operations, gross profit dollars increased 59% on a year-over-year basis while sales increased 74%. Grossprofits for our direct operations, as a percentage of direct revenue decreased from 11% in 2002 to 10% in 2003. This was primarily due toincreased costs related to capacity expansion at the warehouse, as well as an increase in warehouse handling expense as we ramped up staffingand packaging in anticipation of sales increases. Additionally, overall returns costs increased significantly as we increased capacity and staffingfor increased returns volumes due to the returns policy change, and due to process inefficiencies that were identified and fixed during the third andfourth quarters. Cost of goods sold on sales transactions from our fulfillment partners now includes the cost of the product, warehousing and fulfillmentcosts, credit card fees and customer service costs. Therefore, beginning in the third quarter of 2003, overall blended gross margins will besignificantly lower than they have historically been. Now that the costs related to the initial implementation and process refinement of thefulfillment partner returns process have been absorbed in the third quarter, future gross profit dollars generated from these sales should not besignificantly affected by this change. Our fulfillment partner operations generated gross profits of $11.6 million (12% margins) and $9.6 million (78% margins) for the years endedDecember 31, 2003 and 2002, respectively. The increase in the gross profit dollars for our fulfillment partner operations was due to the generalgrowth of the consumer business during the year, and an increase in the number of fulfillment partner products offered on our Websites. Thedecrease in gross margins for our fulfillment partner operations is largely due to the change in our business operations described above as well asan increase in BMV sales from 2% of fulfillment partner revenue in 2002 to 25% in 2003. Margins for BMV products have historically been muchlower than those of other product categories.Operating Expenses Sales and marketing. Sales and marketing expenses totaled $8.7 million and $20.2 million for the years ended December 31, 2002 and2003, representing 9% and 8% of total revenue, respectively. The increased marketing expense reflects increased online marketing efforts,particularly with the large portals (MSN, Yahoo & AOL), and with our affiliate marketing program. In addition, during 2003 we initiated our firstnational radio and television campaign, which added approximately $5.5 million to the marketing expense in the current year over the previousyear. We expect total marketing expenses to continue to increase in the future as a result of the expenses related to online marketing agreementsthat we have recently entered into and similar online or offline radio, television, or other similar agreements that we may enter into in the future.The decrease in sales and marketing as a percentage of total revenue was due to the increase in total revenue in 2003 which was a result of thefulfillment partner returns policy change that occurred beginning the third quarter of 2003. General and administrative. General and administrative expenses increased from $10.8 million in 2002 to $16.9 million in 2003,representing 12% and 7% of total revenue, respectively. The increase in absolute dollars was primarily attributable to costs associated withbuilding infrastructure, including expansion of corporate systems and additional personnel costs from increased corporate headcount. Thedecrease in general and administrative expenses as a percentage of total revenue was due to the increase in total revenue in 2003 which was aresult of the fulfillment partner returns policy change that occurred beginning the third quarter of 2003. Amortization of stock-based compensation. Prior to the Company's initial public offering in May 2002, the Company recorded unearnedstock-based compensation related to stock options granted below the fair market value of the underlying stock. Since the initial public offering, theCompany has not granted any additional stock options below fair market value. Amortization of stock-based compensation was approximately$2.9 million and $756,000 for the years ended December 31, 2002 and 2003, respectively.42 Interest income, interest expense and other income (expense). The increase in interest income from $403,000 in 2002 to $461,000 in 2003is due to the increase in our cash and marketable securities from our follow-on offering in the first quarter of 2003. Interest expense decreasedfrom $465,000 in 2002 to $76,000 in 2003, primarily as a result of our termination of our inventory lines of credit in June 2002 and the reduction inour capital leases. Other income (expense) changed from expense of $444,000 in 2002 to income of $115,000 in 2003 primarily because thecompany paid $439,000 of selling costs on behalf of a selling shareholder as part of the initial public offering in 2002. Income taxes. We incurred net operating losses in 2002 and 2003, and consequently paid insignificant amounts of federal, state andforeign income taxes. As of December 31, 2003, we had $62.4 million of net operating loss carryforwards, of which $14.4 million is subject tolimitation. These net operating loss carryforwards will begin to expire in 2019.Quarterly Results of Operations The following tables set forth our unaudited quarterly results of operations data for the eight most recent quarters for the period endedDecember 31, 2004, as well as such data expressed as a percentage of our total revenue for the periods presented. The information in the tablebelow should be read in conjunction with the Consolidated Financial Statements and the Notes thereto included elsewhere in this Form 10-K. Wehave prepared this information on the same basis as the Consolidated Financial Statements and the information includes all adjustments,consisting only of normal recurring adjustments, that we consider necessary for a fair statement of our financial position and operating results forthe quarters presented. Our quarterly operating results have varied substantially in the past and may vary substantially in the future. You shouldnot draw any conclusions about our future results from the results of operations for any particular quarter. Three Months Ended Mar. 31,2003 June 30,2003 Sept. 30,2003 Dec. 31,2003 Mar. 31,2004 June 30,2004 Sept. 30,2004 Dec. 31,2004 (in thousands, except per share data) Consolidated Statement of Operations Data: Revenue Direct revenue $25,198 $25,402 $29,284 $58,250 $38,580 $41,113 $43,928 $89,589 Fulfillment partner revenue 3,966 3,431 28,504 64,910 43,498 46,679 59,516 131,732 Total revenue 29,164 28,833 57,788 123,160 82,078 87,792 103,444 221,321 Cost of goods sold Direct 23,484 23,014 26,674 51,130 34,816 36,786 38,594 75,194 Fulfillment partner 1,055 1,016 26,863 60,256 38,793 41,114 51,103 112,458 Total cost of goods sold 24,539 24,030 53,537 111,386 73,609 77,900 89,697 187,652 Gross profit 4,625 4,803 4,251 11,774 8,469 9,892 13,747 33,669 Operating expenses: Sales and marketing expenses 3,848 2,572 3,855 9,898 4,377 6,605 9,398 20,153 General and administrative expenses 4,545 3,367 4,059 4,940 6,251 5,567 7,376 11,041 Amortization of stock-based compensation 328 112 171 145 135 123 18 84 Total operating expenses 8,721 6,051 8,085 14,983 10,763 12,295 16,792 31,278 Operating income (loss) (4,096) (1,248) (3,834) (3,209) (2,294) (2,403) (3,045) 2,391 Interest income 152 142 98 69 98 127 168 780 Interest expense (7) (55) (8) (6) (16) (46) (77) (636)Other income (expense), net 10 25 79 1 2 — 3 (54) Net income (loss) (3,941) (1,136) (3,665) (3,145) (2,210) (2,322) (2,951) 2,481 Deemed dividend related to redeemablecommon stock (77) (78) (58) (49) (48) (46) (47) (47) Net income (loss) attributable to commonshares $(4,018)$(1,214)$(3,723)$(3,194)$(2,258)$(2,368)$(2,998)$2,434 Net income (loss) per common share —basic $(0.26)$(0.07)$(0.23)$(0.19)$(0.14)$(0.13)$(0.16)$0.13 —diluted $(0.26)$(0.07)$(0.23)$(0.19)$(0.14)$(0.13)$(0.16)$0.12 Weighted average common shares outstanding —basic 15,486 16,384 16,419 16,473 16,646 17,577 18,284 19,016 —diluted 15,486 16,384 16,419 16,473 16,646 17,577 18,284 20,780 43 Three Months Ended Mar. 31,2003 June 30,2003 Sept. 30,2003 Dec. 31,2003 Mar. 31,2004 June 30,2004 Sept. 30,2004 Dec. 31,2004Additional Operating Data(1): Gross bookings (in thousands)(2) $52,270 $51,315 $61,018 $130,155 $93,412 $96,627 $114,381 $237,021Number of orders(3) 491,000 522,000 643,000 1,376,000 1,126,000 1,023,000 1,178,000 2,440,000Number of new B2C customers(4) 264,000 283,000 342,000 744,000 425,000 414,000 514,000 1,110,000Average customer acquisition cost(5) $14.06 $8.69 $10.97 $13.19 $10.24 $15.88 $18.30 $18.15(1)The additional operating data sets forth certain operating data relating to our business for the eight most recent quarters for the period ended December 31, 2004. While webelieve that the information in the table above facilitates an understanding of our business and results of operations for the periods presented, such information is not inaccordance with generally accepted accounting principles and should be read in conjunction with the quarterly results of operations data set forth above. We believe that grossbookings is a metric widely used in our industry and by making this metric available to investors, we believe investors are able to compare our performance against others in ourindustry. We believe that investors may use the average customer acquisition cost metric to determine how efficiently we are able to achieve growth, if any. Again, we believethis metric is widely used in our industry, and providing these values to investors enables them to make more meaningful comparisons. (2)Gross bookings represents the gross sales price of all sales transactions, including those for which we only record a commission under generally accepted accountingprinciples, and therefore differs from GAAP revenue. Beginning July 1, 2003 we changed our business practices regarding returns, which affected our fulfillment partnerrevenue. As a result, we believe that for year-over-year comparison purposes, gross bookings (non-GAAP) comparisons may be more informative than GAAP revenuecomparisons, as the gross bookings were not affected by the change in business practices. (3)Number of orders represents the number of individual orders for merchandise through our Websites excluding B2B orders. (4)Number of new B2C customers represents the number of valid new customer accounts. To establish a valid customer account, a person must provide us with the followinginformation and purchase merchandise on our B2C Website: a unique e-mail address; a unique password; and a verified credit card account number. (5)Average customer acquisition cost represents total sales and marketing expense divided by the number of new customers for the period presented. Three Months Ended Mar. 31,2003 June 30,2003 Sept. 30,2003 Dec. 31,2003 Mar. 31,2004 June 30,2004 Sept. 30,2004 Dec. 31,2004 (as a percentage of total revenue) Revenue Direct revenue 86.4%88.1%50.7%47.3%47.0%46.8%42.5%40.5% Fulfillment partner revenue 13.6 11.9 49.3 52.7 53.0 53.2 57.5 59.5 Total revenue 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Cost of goods sold Direct 80.5 79.8 46.2 41.5 42.4 41.9 37.3 34.0 Fulfillment partner 3.6 3.5 46.4 48.9 47.3 46.8 49.4 50.8 Total cost of goods sold 84.1 83.3 92.6 90.4 89.7 88.7 86.7 84.8 Gross profit 15.9 16.7 7.4 9.6 10.3 11.3 13.3 15.2 Operating expenses: Sales and marketing expenses 13.2 8.9 6.7 8.0 5.3 7.5 9.1 9.1 General and administrative expenses 15.6 11.7 7.0 4.1 7.6 6.4 7.1 5.0 Amortization of stock-basedcompensation 1.1 0.4 0.3 0.1 0.2 0.1 0.0 0.0 Total operating expenses 29.9 21.0 14.0 12.2 13.1 14.0 16.2 14.1 Operating income (loss) (14.0)(4.3)(6.6)(2.6)(2.8)(2.7)(2.9)1.1 Interest income 0.5 0.5 0.2 0.1 0.1 0.1 0.1 0.3 Interest expense (0.0)(0.2)(0.0)(0.1)(0.0)(0.0)(0.1)(0.3)Other income (expense), net 0.0 0.1 0.1 0.0 0.0 0.0 0.0 (0.0) Net income (loss) (13.5)%(3.9)%(6.3)%(2.6)%(2.7)%(2.6)%(2.9)%1.1% 44 Our direct revenue and fulfillment partner revenue have increased in every quarter on a year-over-year basis. The general increase in totalrevenue is due to the expansion of our customer base as we attracted more visitors to our Websites, as well as repeat purchases from thesecustomers. We have experienced significant seasonality in our business, reflecting a combination of seasonal fluctuations in Internet usage andtraditional retail seasonality patterns. Internet usage and the rate of Internet growth may be expected to decline during the summer. Further, salesin the traditional retail industry are significantly higher in the fourth calendar quarter of each year than in the preceding three quarters. Fulfillmentpartner revenue increased significantly beginning in the third quarter of 2003 due to the change in our business practices. Cost of goods sold as a percentage of total revenue has fluctuated in the quarterly periods reflected above ranging from 83% to 93%. Thesignificant increases during the 3rd and 4th quarters of 2003 relate specifically to the change in business practices in our fulfillment partneroperations and the resulting shift from recognizing revenue on a commission basis to a gross basis. Gross margins during the periods Q4 2003through Q4 2004 were: 9.6%, 10.3%, 11.3%, 13.3% and 15.2%, respectively. In comparing the fourth quarters of 2003 and 2004, revenueincreased 80% (from $123.2 million to $221.3 million) while gross profit dollars increased 186% (from $11.8 million to $33.7 million). Our marginsimprovement stems from our efforts in tightening our logistics costs and achieving better pricing on merchandise purchased to sell on ourWebsites. Total operating expenses as a percentage of gross bookings have generally decreased on a year-over-year basis each quarter during 2004 ascompared to 2003 as a result of economies of scale achieved through increased sales volume. In the near future, we expect to continue to devotesubstantial resources to the expansion of our sales and marketing efforts, and expect that total operating expenses may increase in absolutedollars in future periods. These expenses as a percentage of total revenue will vary depending on the level of revenue obtained. Due to the foregoing factors, in one or more future quarters our operating results may fall below the expectations of securities analysts andinvestors. In such an event, the trading price of our common stock would likely be materially adversely affected.Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on the Company'sfinancial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resourcesthat is material to investors.Liquidity and Capital Resources Prior to the second quarter of 2002, we financed our activities primarily through a series of private sales of equity securities, warrants topurchase our common stock and promissory notes. During the second quarter of 2002, we completed our initial public offering pursuant to whichwe received approximately $26.1 million in cash, net of underwriting discounts, commissions, and other related expenses. Additionally, wecompleted follow-on offerings in February 2003, May 2004 and November 2004, pursuant to which we received approximately $24.0 million,$37.9 million and $75.2 million, respectively, in cash, net of underwriting discounts, commissions, and other related expenses. In November 2004,we also received $116.2 million in proceeds from the issuance of our convertible senior notes in a transaction event exempt from registration underthe Securities Act. At December 31, 2004, our cash and cash equivalents balance was $198.7 million and our marketable securities totaled$88.8 million. Our operating activities resulted in net cash outflows of $10.4 million for the year ended December 31, 2003 and net cash inflows of$25.0 million for the year ended December 31, 2004. The45 primary use of cash and cash equivalents during 2004 was to fund our operations, including net losses of $5.0 million, and changes in inventories($15.4 million), prepaid expenses and other assets ($11.2 million), and other long-term assets ($944,000). This was offset by the change inaccounts receivable ($4.5 million), accounts payable ($33.7 million) and accrued liabilities ($13.6 million). Cash used in investing activities included $8.7 million in capital expenditures for property and equipment and a net decrease of $77.5 millionfrom the purchase and sales of marketable securities. For the years ended December 31, 2003 and 2004, net cash provided by (used in) investingactivities amounted to $3.1 million and $(37.8 million), respectively. Net cash provided by financing activities during the year ended December 31, 2004 was $232.6 million, consisting primarily of net proceedsof $113.1 million received from our follow-on public offerings which occurred in February and November, $116.2 million from the issuance ofconvertible senior notes and approximately $4.3 million received from the exercise of stock options and warrants. Cash flows from financingactivities included $658,000 for payments on capital leases. Net cash provided by financing activities during the year ended December 31, 2003was $25.1 million, consisting primarily of net proceeds of $24.0 million received from the follow-on public offering which occurred in February 2003and approximately $1.2 million received from the exercise of stock options and warrants, offset by $141,000 of payments on capital leases. Contractual Obligations and Commitments. The following table summarizes our contractual obligations as of December 31, 2004 and theeffect such obligations and commitments are expected to have on our liquidity and cash flow in future periods: Payments Due by Period(in thousands)Contractual Obligations Total Less than 1Year 1-3 Years 4-5 Years After 5yearsLong-term debt arrangements $120,000 $— $— $— $120,000Interest on convertible senior notes 31,588 4,588 9,000 9,000 9,000Capital lease obligations 1,420 632 781 7 —Operating leases 50,665 4,099 10,222 10,023 26,321Purchase obligations 7,519 7,519 — — — Total contractual cash obligations $211,192 $16,838 $19,973 $19,030 $155,351 Amounts of Commitment Expiration Per Period(in thousands)Other Commercial Commitments TotalAmountsCommitted Less thanYear 1 1-3 Years 4-5 Years Over 5yearsLetters of credit $8,225 $8,225 $— $— $—Redeemable common stock 3,166 141 3,025 — — Total commercial commitments $11,391 $8,366 $3,025 $— $— In November 2004, we completed an offering of $120.0 million of 3.75% Convertible Senior Notes (the "Senior Notes"). Interest on the SeniorNotes is payable semi-annually on June 1 and December 1 of each year, beginning June 1, 2005. The Senior Notes mature on December 1, 2011and are unsecured and rank equally in right of payment with all existing and future unsecured, unsubordinated debt and senior in right of paymentto any existing and future subordinated indebtedness. The Senior Notes are convertible at any time prior to maturity into our common stock at theoption of the note holders at a conversion price of $76.23 per share or approximately 1,574,000 shares (subject to adjustment in certain events,including stock splits, dividends and other distributions and certain repurchases of our stock, as well as certain fundamental changes in theownership of the Company).46 Beginning December 1, 2009, we have the right to redeem the Senior Notes, in whole or in part, for cash at 100% of the principal amount plusaccrued and unpaid interest. Upon the occurrence of a fundamental change (including the acquisition of a majority interest in the Company, certainchanges in the Company's board of directors or the termination of trading of our stock) meeting certain conditions, holders of the Senior Notes mayrequire us to repurchase for cash all or part of their notes at 100% of the principal amount plus accrued and unpaid interest. The lease obligations include our obligations under a ten-year lease agreement we entered in December 2004 for approximately 143,000square feet of office space in Salt Lake City. We expect to take possession of the new office space in the summer of 2005, and to terminate ourlease obligations under our current office lease agreements at the same time. The total lease obligation over the ten-year term of the new lease is$39.6 million, of which approximately $1.9 million will be payable in 2005. In connection with the preparation of the new office space, we haveagreed to provide a letter of credit for $500,000 to provide funds to discharge our obligations upon termination of the new sublease and have alsoagreed to pay approximately $2.0 million for leasehold improvements. We expect to pay this entire amount for leasehold improvements during2005. The amount of purchase obligations shown is based on assumptions regarding the legal enforceability against us of purchase orders we hadoutstanding at December 31, 2004. Under different assumptions regarding our rights to cancel our purchase orders or different assumptionsregarding the enforceability of the purchase orders under applicable law, the amount of purchase obligations shown in the table above would beless. In May 2004, we entered into a senior secured credit facility for a revolving line of credit of up to $20.0 million. The facility was collateralizedby all of our assets. However, we terminated the facility in December 2004. In December 2004, we replaced the senior secured credit facility described above with an amendment to a credit agreement ("AmendedCredit Agreement") with Wells Fargo Bank, National Association. The existing credit agreement (originally executed in February 2004) provided theCompany with a revolving line of credit for the purpose of issuing up to $10.0 million of letters of credit for the purchase of inventory. The AmendedCredit Agreement provides us a revolving line of credit of up to $30.0 million and expires December 31, 2005. We have an option to renew theAmended Credit Agreement annually. Included in the $30.0 million Amended Credit Agreement is a $10.0 million sub-limit for a revolving line ofcredit which we use to obtain letters of credit to support inventory purchases. At December 31, 2004 the issuing bank or an affiliate of the bankhad letters of credit totaling $8.2 million issued on our behalf under this facility. However, we have no liability for this amount except to the extent,if any, that a beneficiary of any of the outstanding letters of credit draws upon a letter of credit. Interest on the facility is payable monthly and accrues at either (i) one-half of one percentage point (0.50%) above LIBOR in effect on the firstday of an applicable fixed rate term, or (ii) at a fluctuating rate per annum determined by the bank to be one half a percent (0.50%) above dailyLIBOR in effect on each business day a change in daily LIBOR is announced by the bank. Unpaid principal, together with accrued and unpaidinterest is due on December 31, 2005. Borrowings under the facility are collateralized by our cash and marketable securities deposited at WellsFargo or its affiliates, and we are required to maintain balances with Wells Fargo or its affiliates of up to $37.0 million in order to have the fullamount of the credit facility available to us. Consequently, although the facility provides us with some flexibility, it does not increase our liquidity.The Amended Credit Agreement requires us to comply with certain covenants, including restrictions on mergers, business combinations ortransfers of assets. We were in compliance with these covenants at December 31, 2004. At December 31, 2004, there was no outstanding balanceunder the facility except for the outstanding letters of credit.47 The estimated amount of redeemable common stock is based solely on the statutes of limitations of the various states in which stockholdersmay have rescission rights and may not reflect the actual results. The stock is not redeemable by its terms. We do not have any unconditionalpurchase obligations, other long-term obligations, guarantees, standby repurchase obligations or other commercial commitments. In January 2005, the Company's Board of Directors authorized a stock repurchase program under which we may repurchase up to$50.0 million of our common stock through December 31, 2007. Under the program, shares may be purchased as determined by management,from time to time and within certain guidelines, in the open market or in privately negotiated transactions, including privately negotiated structuredstock repurchase transactions and through transactions in the options markets. Depending on market conditions and other factors, thesepurchases may be commenced or suspended at any time or from time to time without prior notice. In February and March 2005, in connection with the buyback program, we entered into several purchased call options, pursuant to which wemay purchase up to 1,250,000 shares of our common stock at certain settlement dates. In connection with these repurchase transactions, wehave paid approximately $47.5 million. Upon settlement, we, at our option, may elect to settle the contracts by physical settlement, net sharesettlement or net cash settlement. Accordingly, we expect to receive either our capital investment returned with a premium or shares of ourcommon stock, depending on whether the market price of our common stock is above or below pre-determined prices agreed in connection witheach such transaction. To the extent that shares of common stock are delivered to us as a result of the transactions described above, the aggregate amount theCompany pays or paid for the repurchase of the shares as a result of these transactions will reduce the amount we might otherwise have spent todirectly repurchase shares from time to time under the stock repurchase program. We believe that the cash and marketable securities currently on hand, amounts available under our credit facility and cash flows fromoperations will be sufficient to continue operations for at least the next twelve months. While we anticipate that, beyond the next twelve months,our cash flows from operations will be sufficient to fund our operational requirements, we may require additional financing. However, there can beno assurance that if additional financing is necessary it will be available, or, if available, that such financing can be obtained on satisfactory terms.Failure to generate sufficient revenues, generate profitability or raise additional capital could have a material adverse effect on our ability tocontinue as a going concern and to achieve our intended business objectives. Any projections of future cash needs and cash flows are subject tosubstantial uncertainty. See "Risk Factors."Seasonality Financial results for Internet retailers are generally seasonal. Based upon the Company's historical experience, increased revenues typicallyoccur during the fourth quarter because of the Christmas retail season. The actual quarterly results for each quarter could differ materiallydepending upon consumer preferences, availability of product and competition, among other risks and uncertainties. Accordingly, there can be noassurances that seasonal variations will not materially affect the Company's results of48 operations in the future. The following table reflects the Company's revenues for each of the quarters available since 2000 (in thousands): FirstQuarter SecondQuarter ThirdQuarter FourthQuarter2004 $82,078 $87,792 $103,444 $221,3212003 29,164 28,833 57,788* 123,1602002 12,067 14,380 23,808 41,5292001 9,578 7,407 8,744 14,2742000 2,257 3,795 4,339 15,132*Note that total revenue since the third quarter of 2003 reflects the change in our policy in which sales by fulfillment partners are recorded"gross" instead of "net" as in prior quarters.Factors That May Affect Future Results Any investment in our securities involves a high degree of risk. Investors should consider carefully the risks and uncertainties describedherein, and all other information in this Form 10-K before deciding whether to purchase or hold our securities. Additional risks and uncertainties notcurrently known to us or that we currently deem immaterial may also become important factors that may harm our business. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We do not use derivative financial instruments in our investment portfolio and have no foreign exchange contracts. Our financial instrumentsconsist of cash and cash equivalents, marketable securities, trade accounts and contracts receivable, accounts payable and long-termobligations. We consider investments in highly-liquid instruments purchased with a remaining maturity of 90 days or less at the date of purchase tobe cash equivalents. Our exposure to market risk for changes in interest rates relates primarily to our short-term investments and short-termobligations; thus, fluctuations in interest rates would not have a material impact on the fair value of these securities. At December 31, 2004, we had $198.7 million in cash and cash equivalents and $88.8 million in marketable securities. A hypotheticalincrease or decrease in interest rates of one hundred basis points would have an estimated impact of approximately $2.9 million on our earnings orloss, or the fair market value or cash flows of these instruments. At December 31, 2004, we had approximately $120.0 million of convertible senior notes outstanding which bear interest at a fixed rate of3.75%. In addition, at December 31, 2004, there were no borrowings outstanding under our line of credit and letters of credit totaling $8.4 millionwere outstanding under our credit facility. The fair value of the convertible senior notes is sensitive to interest rate changes. Interest rate changes would result in increases ordecreases in the fair value of the convertible senior notes, due to differences between market interest rates and rates in effect at the inception ofthe obligation. Unless we elect to repurchase our convertible senior notes in the open market, changes in the fair value of convertible senior noteshave no impact on our cash flows or consolidated financial statements. The estimated fair value of the convertible senior notes was $120.0 millionat December 31, 2004. In January 2005, our Board of Directors authorized a stock repurchase program under which we can repurchase up to $50.0 million of ourcommon stock through December 31, 2007. Under the program, shares may be purchased as determined by management, from time to time andwithin certain guidelines, in the open market or in privately negotiated transactions, including privately negotiated structured stock repurchasetransactions and through transactions in the options markets. Depending49 on market conditions and other factors, these purchases may be commenced or suspended at any time or from time to time without prior notice. In February and March 2005, we entered into several purchased call options, pursuant to which we may purchase up to 1,250,000 shares ofour common stock at certain settlement dates. In connection with these repurchase transactions, we have paid approximately $47.5 million. Uponsettlement, we, at our option, may elect to settle the contracts by physical settlement, net share settlement or net cash settlement. Accordingly,we expect to receive, either our capital investment returned with a premium or shares of our common stock, depending on whether the marketprice of our common stock is above or below pre-determined prices agreed in connection with each such transaction. As a result of these structured stock repurchase transactions, we have market risk exposure to the trading price of our common stock. Theobjective and general strategy of the transactions is to implement a portion of the stock repurchases authorized by our Board of Directors. Theinstruments used to manage our exposure are call spreads which have the economic effect described in the preceding paragraph. We have had nosuch arrangements prior to February 2005. We may enter into similar transactions in the future. At December 31, 2004, we had not entered into any of the structured stock repurchase transactions described herein. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and supplementary data required by this item are included in Part IV, Item 15 of this Form 10-K and are presentedbeginning on page F-1. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. CONTROLS AND PROCEDURES Evaluation of Disclosure Controls and Procedures Under the supervision and with the participation of our management, including our principal executive officer and our principal financial officer,we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) and 15d-15(e) under theSecurities Exchange Act of 1934. Based on this evaluation, our principal executive officer and our principal financial officer concluded that theCompany maintained effective disclosure controls and procedures as of the end of the period covered by this report.Management's Report on Internal Control Over Financial Reporting Management is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined inExchange Act Rule 13a-15(f). In order to evaluate the effectiveness of internal control over financial reporting, as required by Section 404 of theSarbanes-Oxley Act, management conducted an assessment, based on the criteria in Internal Control—Integrated Framework, issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's internal control over financial reporting is designedto provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes inaccordance with generally accepted accounting principles. Because of its inherent limitations, internal control over financial reporting may notprevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may50 become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Based on its evaluation, management concluded that the Company maintained effective internal control over financial reporting as ofDecember 31, 2004, based on the criteria in Internal Control—Integrated Framework issued by the COSO. Management's assessment of theeffectiveness of the Company's internal control over financial reporting as of December 31, 2004, has been audited by PricewaterhouseCoopersLLP, an independent registered public accounting firm, as stated in their report which is included herein.Changes in Internal Controls During the three-month period ended December 31, 2004, there was no change in the Company's internal control over financial reporting thathas materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. ITEM 9B. OTHER INFORMATION None.51 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this Item is incorporated by reference to the Company's definitive proxy statement for the 2005 annual meeting ofstockholders. The Company has adopted a Code of Business Conduct and Ethics, which is applicable to all employees of the Company, including the chiefexecutive officer and senior financial officers, as well as the Board of Directors. The Code includes provisions that are specifically applicable toour senior financial officers. We intend to disclose any amendments to these provisions and any waivers from any of these provisions granted toour directors, chief executive officer and senior financial officers on our Internet Web site, www.overstock.com, within five business days followingany such amendment or waiver. ITEM 11. EXECUTIVE COMPENSATION The information required by this Item is incorporated by reference to the Company's definitive proxy statement for the 2005 annual meeting ofstockholders. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information required by this Item is incorporated by reference to the Company's definitive proxy statement for the 2005 annual meeting ofstockholders. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item is incorporated by reference to the Company's definitive proxy statement for the 2005 annual meeting ofstockholders. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES The information required by this Item is incorporated by reference to the Company's definitive proxy statement for the 2005 annual meeting ofstockholders. ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES (a) 1. Financial Statements INDEX TO CONSOLIDATED FINANCIAL STATEMENTS PageReport of Independent Registered Public Accounting Firm F-2Consolidated Balance Sheets F-4Consolidated Statements of Operations F-5Consolidated Statement of Stockholders' Equity and Comprehensive Income F-6Consolidated Statements of Cash Flows F-7Notes to Consolidated Financial Statements F-8Schedule II Valuation and Qualifying Accounts F-312. Financial Statement Schedules Schedule II Valuation and Qualifying Accounts listed in (a)(1) above is included herein. Schedules other than those listed above have beenomitted as they are either not required, not applicable, or the information has otherwise been shown in the consolidated financial statements ornotes thereto.52 3. Exhibits The exhibits listed below are filed as part of, or incorporated by reference into, this Form 10-K.Exhibit Number Description of Document3.1(a)Amended and Restated Certificate of Incorporation.3.2(a)Amended and Restated Bylaws.4.1(b)Form of specimen common stock certificate.4.2(b)Investor Rights Agreement, dated March 4, 2002.10.1(b)Form of Indemnification Agreement between Overstock.com, Inc. and each of its directors and officers.10.2(b)Amended and Restated 1999 Stock Option Plan and form of agreements thereunder.10.3(b)2001 Stock Purchase Plan and form of agreements thereunder.10.4(b)Gear.com, Inc. Restated 1998 Stock Option Plan and form of agreements thereunder.10.5 Form of agreements under 2002 Stock Option Plan, as amended (incorporated by reference to Exhibit 10.5 to ourRegistration Statement on Form S-1 (File No. 333- 83728), which became effective on May 29, 2002).10.6(b)Agreement and Plan of Merger dated November 3, 2000 by and between Overstock.com, Inc. and Gear.com, Inc.10.7 Lease Agreement dated January 23, 2002 between Overstock.com, Inc. and Holladay Building East L.L.C. (incorporated byreference to Exhibit 10.8 to our Registration Statement on Form S-1 (File No. 333- 83728), which became effective on May29, 2002).10.8 Lease Agreement dated November 27, 2001 between Overstock.com and Holladay Building East L.L.C. (incorporated byreference to Exhibit 10.9 to our Registration Statement on Form S-1 (File No. 333- 83728), which became effective on May29, 2002).10.9 First Lease Extension Agreement dated January 25, 2002 by and between Overstock.com, Inc. and Holladay Building EastL.L.C (incorporated by reference to Exhibit 10.10 to our Registration Statement on Form S-1 (File No. 333- 83728), whichbecame effective on May 29, 2002).10.10 Lease Agreement by and between Overstock.com, Inc. and Marvin L. Oates Trust dated March 15, 2000 (incorporated byreference to Exhibit 10.12 to our Registration Statement on Form S-1 (File No. 333- 83728), which became effective on May29, 2002).10.11 Severance Package Agreement with Douglas Greene dated June 17, 1999 (incorporated by reference to Exhibit 10.13 to ourRegistration Statement on Form S-1 (File No. 333- 83728), which became effective on May 29, 2002).10.12 Intellectual Property Assignment Agreement with Douglas Greene dated February 28, 2002 (incorporated by reference toExhibit 10.14 to our Registration Statement on Form S-1 (File No. 333- 83728), which became effective on May 29, 2002). 53 10.13 Amendment No. 1, dated April 29, 2002 to Intellectual Property Assignment Agreement dated February 28, 2002 by andbetween Overstock.com, Inc. and Douglas Greene. (incorporated by reference to Exhibit 10.18 to our Registration Statementon Form S-1 (File No. 333- 83728), which became effective on May 29, 2002).10.14 Form of Warrant to purchase Overstock.com, Inc. common stock. (incorporated by reference to Exhibit 10.20 to ourRegistration Statement on Form S-1 (File No. 333- 83728), which became effective on May 29, 2002).10.15 Lease Amendment #1 by and between Overstock.com, Inc. and Marvin L. Oates Trust, dated August 28, 2000.(incorporated by reference to Exhibit 10.22 to our Registration Statement on Form S-1 (File No. 333- 102763), which becameeffective on February 12, 2003).10.16 Commencement of Lease Amendment #1 by and between Overstock.com, Inc. and Marvin L. Oates Trust, dated October25, 2000 (incorporated by reference to Exhibit 10.23 to our Registration Statement on Form S-1 (File No. 333- 102763),which became effective on February 12, 2003).10.17 Lease Amendment #2 by and between Overstock.com, Inc. and Marvin L. Oates Trust, dated November 12, 2001.(incorporated by reference to Exhibit 10.24 to our Registration Statement on Form S-1 (File No. 333- 102763), which becameeffective on February 12, 2003).10.18 Lease Amendment #3 by and between Overstock.com, Inc. and Marvin L. Oates Trust, dated July 23, 2002.(incorporated byreference to Exhibit 10.25 to our Registration Statement on Form S-1 (File No. 333- 102763), which became effective onFebruary 12, 2003).10.19 Lease Amendment #4 by and between Overstock.com, Inc. and Marvin L. Oates Trust, dated August 19, 2002.(incorporatedby reference to Exhibit 10.26 to our Registration Statement on Form S-1 (File No. 333- 102763), which became effective onFebruary 12, 2003).10.20 Lease Amendment #5 by and between Overstock.com, Inc. and Marvin L. Oates Trust, dated October 11, 2002.(incorporated by reference to Exhibit 10.27 to our Registration Statement on Form S-1 (File No. 333- 102763), which becameeffective on February 12, 2003).10.21 Lease Amendment #6 by and between Overstock.com, Inc. and Marvin L. Oates Trust, dated December 23, 2002.(incorporated by reference to Exhibit 10.28 to our Registration Statement on Form S-1 (File No. 333- 102763), which becameeffective on February 12, 2003).10.22 Old Mill Corporate Center First Amendment to the Lease Agreement by and between Overstock.com, Inc. and HolladayBuilding East L.L.C., dated September 1, 2002.(incorporated by reference to Exhibit 10.29 to our Registration Statement onForm S-1 (File No. 333-102763), which became effective on February 12, 2003).10.23 Credit Agreement dated February 13, 2004 between Overstock.com, Inc. and Wells Fargo Bank National Association(incorporated by reference to Exhibit 10.31 to our Annual Report on Form 10-K for the year ended December 31, 2003 filedon February 24, 2004). 54 10.24 Amendment to Credit Agreement by and between Overstock.com, Inc., and Wells Fargo Bank, National Association datedDecember 22, 2004. (incorporated by reference to Exhibit 99.1 to our Report on Form 8-K filed on December 27, 2004).10.25 Term sheet executed February 18, 2005 with Lehman Brothers OTC Derivatives Inc.(incorporated by reference to Exhibit99.1 to our Report on Form 8-K filed on February 24, 2005).10.26 Tenant Improvement Agreement by and between Overstock.com, Inc. and old Mill Corporate Center III, LLC entered onFebruary 11, 2005 (incorporated by reference to Exhibit 99.1 to our Report on Form 8-K filed on February 11, 2005).10.27 Sublease Agreement by and between Overstock.com, Inc., Old Mill Technology Center, LLC, and Old Mill Building LLC.(incorporated by reference to Exhibit 99.1 to our Report on Form 8-K/A filed on December 7, 2004).10.28 Sublease Agreement by and between Overstock.com, Inc., Document Controls Systems, Inc., and Old Mill Building LLC.(incorporated by reference to Exhibit 99.2 to our Report on Form 8-K/A filed on December 7, 2004).10.29 Sublease Agreement by and between Overstock.com, Inc., Information Technology International, Inc., and Old Mill BuildingLLC. (incorporated by reference to Exhibit 99.3 to our Report on Form 8-K/A filed on December 7, 2004).10.30 Old Mill Corporate Center Fourth Amendment to the Lease Agreement. (incorporated by reference to Exhibit 99.4 to ourReport on Form 8-K/A filed on December 7, 2004).10.31 Co-location Center Agreement. (incorporated by reference to Exhibit 99.5 to our Report on Form 8-K/A filed on December 7,2004).10.32 Indenture, dated November 23, 2004, between Overstock.com, Inc. and Wells Fargo Bank, N.A., as trustee. (incorporatedby reference to Exhibit 10.1 to our Report on Form 8-K filed on November 24, 2004).10.33 Registration Rights Agreement, dated November 23, 2004 by and among Overstock.com, Inc., Lehman Brothers., PiperJaffray & Co., Legg Mason Wood Walker Incorporated and WR Hambrecht + Co, LLC (incorporated by reference toExhibit 10.2 to our Report on Form 8-K filed on November 24, 2004).10.34 Purchase Agreement dated November 17, 2004 with Lehman Brothers Inc. as Representative10.35 Underwriting Agreement dated November 17, 2004 with Lehman Brothers Inc. as Representative (incorporated by referenceto Exhibit 1.1 to our Report on Form 8-K filed on November 18, 2004)10.36 Underwriting Agreement dated May 13, 2004 with WR Hambrecht & Co., LLC and JMP Securities LLC. as Representatives(incorporated by reference to Exhibit 1.1 to our Report on Form 8-K filed on May 14, 200410.37 2002 Stock Option Plan, as amended (incorporated by reference to Exhibit 99.6 to our Report on Form 8-K filed May 7,2004)10.38(c)Summary of Compensation Arrangements Applicable to Named Executive Officers.10.39(c)Summary of Compensation Arrangements Applicable to Non-employee Directors.21 Subsidiaries of the Registrant 55 23.1 Consent of Independent Registered Public Accounting Firm24.1 Power of Attorney (see signature page)31.1 Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer31.2 Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer32.1 Section 1350 Certification of Chief Executive Officer32.2 Section 1350 Certification of Chief Financial Officer(a)Incorporated by reference to exhibits of the same number filed with our Form 10-Q (File No. 000-49799), filed on August 13, 2002. (b)Incorporated by reference to exhibits of the same number filed with our Registration Statement on Form S-1 (File No. 333-83728), whichbecame effective on May 29, 2002. (c)Management contract or compensatory plan or arrangement.56 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the registrant has duly caused this report to be signed onits behalf by the undersigned, thereunto duly authorized, on March 15, 2005. OVERSTOCK.COM, INC. By:/s/ PATRICK M. BYRNE Patrick M. ByrneChairman and PresidentPOWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints each of PatrickM. Byrne, Jonathan E. Johnson III and David K. Chidester, his or her attorneys-in-fact, each with the power of substitution, for him or her in anyand all capacities, to sign any amendments to this Annual Report on Form 10-K, and to file the same, with exhibits thereto and other documents inconnection therewith, with the Securities and Exchange Commission, hereby ratifying and conforming all that said attorney-in-fact, or his or theirsubstitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf ofthe registrant and in the capacities and on the dates indicated.Signature Title Date /s/ PATRICK M. BYRNE Patrick M. Byrne President and Chairman of the Board (PrincipalExecutive Officer) March 15, 2005/s/ DAVID K. CHIDESTER David K. Chidester Vice President, Finance (Principal Financial Officer andPrincipal Accounting Officer) March 15, 2005/s/ GORDON S. MACKLIN Gordon S. Macklin Director March 15, 2005/s/ ALLISON H. ABRAHAM Allison H. Abraham Director March 15, 2005/s/ JOHN A. FISHER John A. Fisher Director March 15, 2005/s/ JACK J. BYRNE Jack J. Byrne Director March 15, 200557 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Report of Independent Registered Public Accounting FirmConsolidated Balance SheetsConsolidated Statements of OperationsConsolidated Statement of Stockholders' Equity and Comprehensive IncomeConsolidated Statements of Cash FlowsNotes to Consolidated Financial StatementsSchedule II Valuation and Qualifying AccountsF-1 Report of Independent Registered Public Accounting Firm To the Board of Directors andStockholders of Overstock.com, Inc.: We have completed an integrated audit of Overstock.com, Inc.'s 2004 consolidated financial statements and of its internal control overfinancial reporting as of December 31, 2004 and audits of its 2003 and 2002 consolidated financial statements in accordance with the standards ofthe Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.Consolidated financial statements and financial statement schedule In our opinion, the consolidated financial statements listed in the index appearing on page F-1 present fairly, in all material respects, thefinancial position of Overstock.com, Inc. and its subsidiaries at December 31, 2004 and 2003, and the results of their operations and their cashflows for each of the three years in the period ended December 31, 2004 in conformity with accounting principles generally accepted in the UnitedStates of America. In addition, in our opinion, the financial statement schedule listed in the index appearing on page F-1 presents fairly, in allmaterial respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financialstatements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion onthese financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance withthe standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includesexamining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our auditsprovide a reasonable basis for our opinion.Internal control over financial reporting Also, in our opinion, management's assessment, included in "Management's Report on Internal Control Over Financial Reporting," appearingin Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2004 based on criteria established inInternal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairlystated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effectiveinternal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued bythe COSO. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment ofthe effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management's assessment and on theeffectiveness of the Company's internal control over financial reporting based on our audit. We conducted our audit of internal control over financialreporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in allmaterial respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting,evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such otherprocedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.F-2 A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Acompany's internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurancethat transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directorsof the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition ofthe company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of anyevaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or thatthe degree of compliance with the policies or procedures may deteriorate. /s/ PricewaterhouseCoopers LLPSalt Lake City, UtahMarch 14, 2005F-3 Overstock.com, Inc. Consolidated Balance Sheets December 31, 2003 2004 (in thousands) Assets Current assets: Cash and cash equivalents $28,846 $198,678 Marketable securities 11,500 88,802 Cash, cash equivalents and marketable securities 40,346 287,480 Accounts receivable, net 10,183 5,715 Inventories, net 29,926 45,279 Prepaid inventory 2,946 12,322 Prepaid expenses 1,637 3,444 Total current assets 85,038 354,240 Restricted cash — 1,602 Property and equipment, net 9,483 16,122 Goodwill 2,784 2,784 Other long-term assets, net 427 1,516 Total assets $97,732 $376,264 Liabilities, Redeemable Securities and Stockholders' Equity Current liabilities: Accounts payable $30,363 $64,060 Accrued liabilities 9,316 22,917 Capital lease obligations, current 75 595 Total current liabilities 39,754 87,572 Capital lease obligations, non-current 86 743 Convertible senior notes — 116,251 Total liabilities 39,840 204,566 Commitments and contingencies (notes 10, 11 and 12) Redeemable common stock, $0.0001 par value, 460 shares issued and outstanding as ofDecember 31, 2003 and 2004 2,978 3,166 Stockholders' equity: Preferred stock, $0.0001 par value, 5,000 shares authorized, no shares issued and outstanding asof December 31, 2003 and 2004 — — Common stock, $0.0001 par value, 100,000 shares authorized, 16,060 and 19,390 shares issued asof December 31, 2003 and 2004, respectively 2 2 Additional paid-in capital 123,934 243,131 Accumulated deficit (67,815) (73,005) Unearned stock-based compensation (1,094) (1,301) Treasury stock, 35 shares at cost (100) (100) Accumulated other comprehensive loss (13) (195) Total stockholders' equity 54,914 168,532 Total liabilities, redeemable securities and stockholders' equity $97,732 $376,264 The accompanying notes are an integral part of these consolidated financial statements.F-4 Overstock.com, Inc. Consolidated Statements of Operations Year ended December 31, 2002 2003 2004 (in thousands, except per share data) Revenue Direct revenue $79,405 $138,134 $213,210 Fulfillment partner revenue 12,379 100,811 281,425 Total revenue 91,784 238,945 494,635 Cost of goods sold Direct 70,686 124,302 185,390 Fulfillment partner 2,755 89,190 243,468 Total cost of goods sold (includes amortization of stock-based compensation of$373, $90, and $0, respectively) 73,441 213,492 428,858 Gross profit 18,343 25,453 65,777 Operating expenses: Sales and marketing expenses (excludes amortization of stock-basedcompensation of $83, $22, and $0, respectively) 8,669 20,173 40,533 General and administrative expenses (excludes amortization of stock-basedcompensation of $2,820, $734, and $360, respectively) 10,825 16,911 30,235 Amortization of stock-based compensation 2,903 756 360 Total operating expenses 22,397 37,840 71,128 Operating loss (4,054) (12,387) (5,351)Interest income 403 461 1,173 Interest expense (465) (76) (775)Other income (expense), net (444) 115 (49) Net loss (4,560) (11,887) (5,002)Deemed dividend related to redeemable common stock (406) (262) (188)Deemed dividend related to beneficial conversion feature of preferred stock (6,607) — — Net loss attributable to common shares $(11,573)$(12,149)$(5,190) Net loss per common share—basic and diluted $(0.88)$(0.75)$(0.29)Weighted average common shares outstanding—basic and diluted 13,108 16,198 17,846 The accompanying notes are an integral part of these consolidated financial statements.F-5 Overstock.com, Inc. Consolidated Statements of Stockholders' Equityand Comprehensive Income Common stock AccumulatedOtherComprehensiveIncome (Loss) AdditionalPaid-incapital Accumulateddeficit Unearnedstock-basedcompensation Treasurystock Shares Amount Total (amounts in thousands) Balance at December 31, 2001 10,327 $1 $52,187 $(44,093)$(2,015)$(100)$— $5,980 Issuance of common stock 7 — 212 — — — — 212 Exercise of stock options and warrants 149 — 615 — — — — 615 Deemed dividend related to beneficialconversion feature of preferred stock — — 6,607 (6,607) — — — — Conversion of Series A redeemablepreferred stock to common stock 959 — 6,582 — — — — 6,582 Issuance of common stock in IPO 2,256 — 26,140 — — — — 26,140 Unearned stock-based compensationfrom options issued to employees — — 3,481 — (3,481) — — — Amortization of stock-basedcompensation — — — — 3,276 — — 3,276 Stock-based compensation to consultantsin exchange for services — — 131 — (107) — — 24 Lapse of rescission rights on redeemablecommon stock 168 — 1,327 — — — — 1,327 Deemed dividend related to redeemablecommon stock — — — (406) — — — (406)Net loss — — — (4,560) — — — (4,560)Unrealized gain on marketable securities — — — — — — 81 81 Total comprehensive loss (4,479) Balance at December 31, 2002 13,866 1 97,282 (55,666) (2,327) (100) 81 39,271 Exercise of stock options and warrants 247 — 1,227 — — — — 1,227 Issuance of common stock in follow-onoffering 1,725 1 23,967 — — — — 23,968 Issuance of common stock — — 21 — — — — 21 Forfeitures of unearned stock-basedcompensation from options issued toemployees — — (478) — 478 — — — Amortization of stock-basedcompensation — — — — 846 — — 846 Stock-based compensation to consultantsin exchange for services — — 268 — (91) — — 177 Lapse of rescission rights on redeemablecommon stock 222 — 1,647 — — — — 1,647 Deemed dividend related to redeemablecommon stock — — — (262) — — — (262)Net loss — — — (11,887) — — — (11,887)Realized gain on marketable securities — — — — — — (15) (15)Unrealized loss on marketable securities — — — — — — (78) (78)Cumulative translation adjustment — — — — — — (1) (1) Total comprehensive loss (11,981) Balance at December 31, 2003 16,060 2 123,934 (67,815) (1,094) (100) (13) 54,914 Exercise of stock options and warrants 650 — 4,288 — — — — 4,288 Issuance of common stock in follow-onofferings 2,680 — 113,064 — — — — 113,064 Forfeitures of unearned stock-basedcompensation from options issued toemployees — — (198) — 198 — — — Amortization of stock-basedcompensation — — — — 360 — — 360 Stock-based compensation to consultantsin exchange for services — — 2,043 — (765) — — 1,278 Deemed dividend related to redeemablecommon stock — — — (188) — — — (188)Net loss — — — (5,002) — — — (5,002)Realized gain on marketable securities — — — — — — (2) (2)Unrealized loss on marketable securities — — — — — — (202) (202)Cumulative translation adjustment — — — — — — 22 22 Total comprehensive loss (5,184) Balance at December 31, 2004 19,390 $2 $243,131 $(73,005)$(1,301)$(100)$(195)$168,532 The accompanying notes are an integral part of these consolidated financial statements.F-6 Overstock.com, Inc. Consolidated Statements of Cash Flows Year ended December 31, 2002 2003 2004 (in thousands) Cash flows from operating activities: Net loss $(4,560)$(11,887)$(5,002) Adjustments to reconcile net loss to net cash provided by (used in) operating activities: Depreciation and amortization 1,873 2,325 3,937 Amortization of unearned stock-based compensation 3,276 846 360 Loss on disposition of property and equipment — — 34 Realized loss (gain) on marketable securities 55 (15) (2) Stock-based compensation to consultants for services 24 177 1,278 Stock issued to employees 181 21 — Amortization of debt discount and deferred financing fees 242 — 147 Selling shareholder fees 439 — — Changes in operating assets and liabilities: Accounts receivable, net (5,429) (3,189) 4,468 Inventories, net (6,368) (15,972) (15,353) Prepaid inventory (1,099) (1,584) (9,376) Prepaid expenses (758) (666) (1,807) Other long-term assets 246 (7) (944) Accounts payable 10,051 16,632 33,697 Accrued liabilities 4,316 2,907 13,601 Net cash provided by (used in) operating activities 2,489 (10,412) 25,038 Cash flows from investing activities: Increase in restricted cash — — (1,602) Purchases of marketable securities (34,819) (41,363) (92,877) Sales of marketable securities 13,243 51,388 15,373 Expenditures for property and equipment (1,746) (6,707) (8,734) Proceeds from the sale of property and equipment — — 20 Expenditures for other long-term assets (5) (172) — Net cash provided by (used in) investing activities (23,327) 3,146 (87,820) Cash flows from financing activities: Payments on capital lease obligations (261) (141) (658) Borrowings on related party note payables 1,160 — — Payments on related party note payables (5,660) — — Drawdown on line of credit — — 1,000 Payments on line of credit — — (1,000) Payments of deferred financing fees — — (301) Proceeds from the issuance of convertible senior notes — — 116,199 Issuance of redeemable preferred stock 6,582 — — Issuance of common stock in offerings, net of issuance costs 26,140 23,968 113,064 Payment of selling shareholder fees (439) — — Issuance of common stock 31 — — Exercise of stock options and warrants 615 1,227 4,288 Net cash provided by financing activities 28,168 25,054 232,592 Effect of exchange rate changes on cash — (1) 22 Net increase in cash and cash equivalents 7,330 17,787 169,832 Cash and cash equivalents, beginning of year 3,729 11,059 28,846 Cash and cash equivalents, end of year $11,059 $28,846 $198,678 Supplemental disclosures of cash flow information: Interest paid $222 $51 $165 Equipment and software acquired under capital leases 25 120 1,835 Deemed dividend on redeemable common stock 406 262 188 Deemed dividend related to beneficial conversion feature of redeemable preferred stock 6,607 — — Conversion of Series A preferred stock to common stock 6,582 — — Unearned stock-based compensation (forfeitures) 3,481 (478) (198) Lapse of rescission rights on redeemable common stock 1,327 1,647 — The accompanying notes are an integral part of these consolidated financial statements.F-7 Overstock.com, Inc. Notes to Consolidated Financial Statements (all amounts in thousands, except per share data) 1. BUSINESS AND ORGANIZATION Overstock.com, Inc. (the "Company") is an online "closeout" retailer offering discount, brand-name merchandise for sale primarily over theInternet. The Company's merchandise offerings include bed-and-bath goods, furniture, kitchenware, watches, jewelry, computers and electronics,sporting goods, apparel and designer accessories. The Company also sells books, magazines, CDs, DVDs, videocassettes and video games. The Company was formed on May 5, 1997 as D2—Discounts Direct, a limited liability company. On December 30, 1998, the Company wasreorganized as a C Corporation in the State of Utah and reincorporated in Delaware in May 2002. On October 25, 1999, the Company changed itsname to Overstock.com, Inc. On November 20, 2000, the Company acquired Gear.com, Inc. On July 23, 2003, the Company formed OverstockMexico, S. de R. L. de C.V., a wholly owned subsidiary, to distribute products in Mexico.2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIESPrinciples of consolidation The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. The 2004consolidated financial statements also include the accounts of a variable interest entity for which the Company is the primary beneficiary(Note 20). All significant intercompany account balances and transactions have been eliminated in consolidation.Use of estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of thefinancial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from thoseestimates.Fair value of financial instruments Cash equivalents include short-term, highly liquid instruments with original maturities of 90 days or less. At December 31, 2003 and 2004,three banks held the Company's cash and cash equivalents. The Company does not believe that, as a result of this concentration, it is subject toany unusual financial risk beyond the normal risk associated with commercial banking relationships. The Company's financial instruments,including cash, cash equivalents, accounts receivable, accounts payable and accrued liabilities are carried at cost, which approximates their fairvalue because of the short-term maturity of these instruments. The estimated fair value of the Company's 3.75% Convertible Senior Notes isapproximately $120,000. Marketable securities consist of funds deposited into capital management accounts managed by two financial institutions. The financialinstitutions have invested these funds in municipal, government and corporate bonds and money market securities which are classified asavailable-for-sale and reported at fair value using the specific identification method. Realized gains and losses are included in other income(expense), net in the Consolidated Statements of Operations. Unrealized gains and losses are excluded from earnings and reported as acomponent of other comprehensive income (loss), net of related estimated tax provisions or benefits.F-8 Accounts receivable Accounts receivable consist of trade amounts due from customers and from credit cards billed but not yet received at period end. Accountsreceivable are recorded at invoiced amounts and do not bear interest. The Company evaluates its allowance for doubtful accounts monthly.Account balances are written-off against the allowance when it is probable that the receivable will not be recovered. The Company recorded anallowance for doubtful accounts of $650 and $750 at December 31, 2003 and 2004, respectively.Concentration of credit risk Financial instruments that potentially subject the Company to significant concentrations of credit risk consist primarily of cash equivalents,investment securities, and receivables. The Company invests its cash primarily in money market, government and corporate securities which areuninsured. The Company's accounts receivable are derived primarily from revenue earned from customers located in the United States. The Companymaintains an allowance for doubtful accounts based upon the expected collectibility of accounts receivable.Prepaid inventory Prepaid inventory represents inventory paid for in advance of receipt. Prepaid inventory at December 31, 2003 and 2004 was $2,946 and$12,322, respectively.Prepaid expenses Prepaid expenses represent expenses paid for prior to receipt of the related goods or services, including advertising, maintenance,packaging, insurance and other miscellaneous costs. Total prepaid expenses at December 31, 2003 and 2004 were $1,637 and $3,444,respectively.Inventories Inventories consist of merchandise purchased for resale and are stated at the lower of average cost or market. The Company establishesreserves for estimated obsolescence or damage equal to the difference between the cost of inventory and the estimated market value based uponassumptions about future demand and market conditions.Property and equipment Property and equipment, which includes capitalized leases, are recorded at cost and depreciated using the straight-line method over theestimated useful lives of the related assets or the term of the related lease, whichever is shorter, as follows: YearsComputer software 3Computer hardware 3-5Furniture and equipment 3-5F-9 Leasehold improvements are amortized over the shorter of the term of the related leases or estimated service lives. Upon sale or retirementof assets, cost and related accumulated depreciation are removed from the balance sheet and the resulting gain or loss is reflected in theconsolidated statement of operations.Other long-term assets Other long-term assets include deposits and the cost of acquiring the Overstock.com and other related domain names. The cost of thedomain names is being amortized using the straight-line method over 5 years.Goodwill Goodwill represents the excess of the purchase price paid over the fair value of the tangible net assets acquired for the purchase ofGear.com. In accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, goodwill is not amortizedbut tested for impairment at least annually. The Company evaluated the $2,784 of unamortized goodwill during 2002, 2003 and 2004, anddetermined that no impairment charge should be recorded.Impairment of long-lived assets The Company reviews property and equipment and other long-lived assets for impairment whenever events or changes in circumstancesindicate that the carrying amount of an asset may not be recoverable. Recoverability is measured by comparison of the assets' carrying amount tofuture undiscounted net cash flows the assets are expected to generate. Cash flow forecasts are based on trends of historical performance andmanagement's estimate of future performance, giving consideration to existing and anticipated competitive and economic conditions. If suchassets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assetsexceeds the projected discounted future cash flows arising from the assets or their fair values, whichever is more determinable. The Company didnot record any impairments during 2002, 2003 and 2004.Revenue recognition The Company derives its revenue primarily from two sources: direct revenue and fulfillment partner revenue, including listing fees andcommissions collected from products being listed and sold through the Auctions tab of its Website. Both direct revenue and fulfillment partnerrevenue are recorded net of returns, coupons redeemed by customers, and other discounts. Revenue is recognized when the following revenuerecognition criteria are met: (1) persuasive evidence of an arrangement exists; (2) the product has been shipped and the customer takes ownershipand assumes the risk of loss or the service has been provided; (3) the selling price or fee revenue earned is fixed or determinable; and(4) collection of the resulting receivable is reasonably assured. The Company generally requires payment by credit card at the point of sale.Amounts received prior to shipment of products or service is recorded as deferred revenue. In addition, amounts received in advance for Club Oand Club O Gold membership fees are recorded as deferred revenue and recognized ratably over the membershipF-10 period. The Company maintains a reserve for returns based on estimates of future product returns related to current period revenues.Direct revenue Direct revenue consists of merchandise sales made to individual consumers and businesses that are fulfilled from the Company's leasedwarehouses. The Company generally requires payment by credit card at the point of sale. From time to time, the Company grants credit to itsbusiness customers on normal credit terms. Amounts received prior to shipment of goods to customers are recorded as deferred revenue. Directrevenue is recorded net of estimated returns, chargebacks and coupons redeemed by customers and other discounts to obtain such sales.Fulfillment partner revenue Fulfillment partner revenue consists of merchandise sold through the Company's Website and shipped by third parties directly to consumersand other businesses, and is recognized when services have been rendered (generally when verification of the shipment of the product iscommunicated to the Company from the third party that shipped the product). Prior to July 1, 2003, the Company did not physically handle themerchandise sold in these transactions, as the merchandise was shipped directly by a third party vendor, who also handled all customer returnsrelated to these fulfillment partner sales. During that period, the Company recognized as revenue only the net portion of the price customers paidfor the purchased products since the Company acted as an agent in such transactions. Beginning July 1, 2003, the Company took responsibilityfor returned items relating to these sales and began accepting returned items relating to these sales into the Company's warehouse, and theCompany now handles the possible resale of returned items. As a result, beginning July 1, 2003, the Company is considered to be the primaryobligor for these sales transactions, and assumes the risk of loss on returned items. As a consequence, the Company now records revenue fromsales transactions involving fulfillment partners on a gross basis, rather than on a net basis as was recorded prior to July 1, 2003. During September 2004, the Company added an online auction service to its Website. The Auctions tab allows sellers to list items for sale,buyers to bid on items of interest, and users to browse through listed items online. The Company is not considered the seller of the items sold onthe auction site and has no control over the pricing of those items. Therefore, for these sales, only the listing fees for items listed andcommissions for items sold are recorded as revenue during the period items are listed or items are sold. Our auction business revenues wereinsignificant in 2004. Revenue from the auctions business is included in the fulfillment partner segment in 2004, as it is not large enough toseparate out as its own segment at this early stage of the business. During the fourth quarter of 2003, the Company added a discount travel store to its Website. The Company used fulfillment partners to supplythe travel products and services (flights, hotels, rental cars, etc.). For the products and services sold in the travel store, the Company did not haveinventory risk or pricing control, and did not provide customer service. Therefore, for these sales the Company was not considered to be theprimary obligor, and recorded only the commission as revenue in the period the transaction occurred. In May 2004, the Company closed its travelstore in order to make improvements to the travel product offerings. The Company reopened its travel store in January 2005. During 2003 and2004, revenues from the Travel store were insignificant.F-11 Fulfillment partner revenue is reduced by the impact of estimated returns, chargebacks and coupons redeemed by customers and otherdiscounts to obtain such sales. Total revenue is recorded net of estimated returns, coupons and other discounts. Our returns policy for all products other than those sold inour Electronics and Computers department provides for a $4.95 restocking fee and the provision that we will not accept product returns initiatedmore than twenty days after the shipment date. We charge a 15% restocking fee (instead of the $4.95 restocking fee) on all items returned for non-defective reasons from the Electronics and Computers department.Cost of goods sold Cost of goods sold include product costs, warehousing costs, inbound and outbound shipping costs, handling and fulfillment costs, customerservice costs and credit card fees, and are recorded in the same period in which related revenues have been recorded. Fulfillment costs includewarehouse handling labor costs, fixed warehouse costs, credit card fees and customer service costs. For the years ended December 31, 2002,2003 and 2004, fulfillment costs totaled $9,373, $20,302 and $34,278, respectively.Income taxes Income taxes are accounted for under the asset and liability method. Deferred income tax assets and liabilities are recognized for the futuretax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and theirrespective tax basis using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. Valuationallowances are established when necessary to reduce deferred tax assets to the amounts expected to be ultimately realized. Income tax expense(benefit) is the tax payable (receivable) for the period and the change during the period in the deferred tax assets and liabilities.Stock-based compensation The Company measures compensation expense to employees for its equity incentive plan using the intrinsic value method prescribed byAccounting Principles Board Opinion No. 25 ("APB 25"), Accounting for Stock Issued to Employees, and provides pro forma disclosures of netincome as if the fair value based method prescribed by Statement of Financial Accounting Standards ("SFAS") No. 123, Accounting for Stock-Based Compensation, had been applied (Note 14). The following table provides aF-12 reconciliation of net loss to pro forma net loss as if the fair value method had been applied to all awards. Year ended December 31, 2002 2003 2004 Net loss, as reported $(4,560)$(11,887)$(5,002)Add: Stock-based employee compensation expense included in reported net income netof related tax effects 3,276 846 360 Deduct: Total stock-based employee compensation expense determined under fair valuebased method for all awards, net of related tax effects (4,404) (2,714) (3,747) Pro forma net loss $(5,688)$(13,755)$(8,389) Net loss per common share Basic and diluted—as reported $(0.88)$(0.75)$(0.29) Basic and diluted—pro forma $(0.97)$(0.87)$(0.48) The weighted average grant-date fair value of options granted during 2002, 2003 and 2004 was $8.21, $8.27 and $15.39 per share,respectively, and was estimated using the assumptions discussed in Note 14. Stock-based awards to non-employees are accounted for under the provisions of FAS 123 and Emerging Issues Task Force Issue 96-18,Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.Earnings (loss) per share Basic earnings (loss) per share is computed by dividing net income (loss) attributable to common shares by the weighted average number ofcommon shares outstanding during the period. Diluted earnings (loss) per share assumes the exercise of all options and warrants which aredilutive using the treasury stock method (whether exercisable or not) and assumes the conversion of convertible senior notes, if dilutive, using the"if converted" method.F-13 The following table sets forth the computation of basic and diluted earnings (loss) per share for the periods indicated: Year ended December 31, 2002 2003 2004 Net loss attributable to common shares $(11,573)$(12,149)$(5,190) Weighted average common shares outstanding—basic 13,108 16,198 17,846 Effective of dilutive securities: Warrants — — — Employee stock options — — — Convertible senior notes — — — Weighted average common shares outstanding—diluted 13,108 16,198 17,846 Earnings (loss) per common share—basic: $(0.88)$(0.75)$(0.29)Earnings (loss) per common share—diluted: $(0.88)$(0.75)$(0.29) The stock options, warrants and convertible senior notes outstanding were not included in the computation of diluted earnings per sharebecause to do so would have been antidilutive. The number of shares of stock options and warrants outstanding at each year-end was 2,535shares, 2,849 shares and 2,399 shares for 2002, 2003 and 2004, respectively. As of December 31, 2004, the Company had $120,000 ofconvertible senior notes outstanding (Note 10), which could potentially convert into 1,574 shares of common stock in the aggregate.Internal use software The Company expenses all costs incurred for the development of internal use software that relate to the planning and post implementationphases of the development. Direct costs incurred in the development phase are capitalized and recognized over the software's estimated usefullife of 3 years. Research and development costs and other computer software maintenance costs related to software development are expensedas incurred.Advertising expense The Company recognizes advertising expenses in accordance with SOP 93-7 Reporting on Advertising Costs. As such, the Companyexpenses the costs of producing advertisements at the time production occurs, and expenses the cost of communicating advertising in the periodduring which the advertising space or airtime is used. Internet advertising expenses are recognized based on the terms of the individualagreements, which is generally: 1) during the period customers are acquired; or 2) based on the number of clicks generated during a given periodover the term of the contract. Advertising expenses totaled $7,043, $18,552 and $39,180 during the years ended December 31, 2002, 2003 and2004, respectively.Foreign currency translation For the Company's subsidiary located in Mexico, the subsidiary's local currency is considered its functional currency. As a result, all of thesubsidiary's assets and liabilities are translated into U.S.F-14 dollars at exchange rates existing at the balance sheet dates, revenue and expenses are translated at weighted average exchange rates, andstockholders' equity is recorded at historical exchange rates. The resulting foreign currency translation adjustments are recorded as a separatecomponent of stockholders' equity in the consolidated balance sheets as part of accumulated other comprehensive income (loss). Transactiongains and losses are included in other income (expense) in the consolidated financial statements and have not been significant for any periodspresented.Recently issued accounting pronouncements In December 2004, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard ("SFAS")No. 123 (revised 2004) Share-Based Payment. This standard requires companies to measure and recognize the cost of employee servicesreceived in exchange for an award of equity instruments based on the grant-date fair value. The effective date is the first interim reporting periodbeginning after June 15, 2005. The Company is currently evaluating pricing models and the transition provisions of this standard and will beginexpensing stock options in the third quarter of 2005. In November 2004, the FASB issued SFAS No. 151, Inventory Costs—an Amendment of ARB No. 43, Chapter 4. This standard providesclarification that abnormal amounts of idle facility expense, freight, handling costs, and spoilage should be recognized as current-period charges.Additionally, this standard requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of theproduction facilities. The provisions of this standard are effective for inventory costs incurred during fiscal years beginning after June 15, 2005.The adoption of this standard is not expected to have a material impact to the Company's financial statements. In March 2004, the FASB issued EITF Issue No. 03-1 ("EITF 03-1"), The Meaning of Other-than-Temporary Impairments and its Applicationto Certain Investments, which provides new guidance for assessing impairment losses on investments. Additionally, EITF 03-1 includes newdisclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB delayed the accountingprovisions of EITF 03-1; however, the disclosure requirements remain effective for annual periods ending after June 15, 2004. The Company willevaluate the impact of EITF 03-1 once final guidance is issued.3. PUBLIC OFFERINGS On June 4, 2002, the Company closed its initial public offering, pursuant to which it sold 2,155 shares of its common stock, and a sellingshareholder sold 845 shares of common stock at a price of $13.00 per share. The offering resulted in proceeds to the Company of approximately$24,880, net of $2,014 of issuance costs. As part of the offering, the Company granted the underwriter the right to purchase up to 450 additionalshares within thirty days after the offering to cover over-allotments. On June 27, 2002, the underwriter purchased an additional 101 shares of stockfor $1,260. At the closing of the offering, all issued and outstanding shares of the Company's redeemable convertible preferred stock wereautomatically converted into common stock on a 1:1 basis. As part of the initial public offering, the Company paid $439 of selling costs on behalf of the selling shareholder. This amount was recorded inother income (expense) in the statement of operations for the year ended December 31, 2002.F-15 In February 2003, the Company closed its follow-on public offering, pursuant to which it sold 1,725 shares of common stock, with proceedsto the Company of approximately $23,968, net of $613 of issuance costs. In June 2004, the Company closed its second follow-on public offering, pursuant to which it sold 1,300 shares of common stock, withproceeds to the Company of approximately $37,857, net of $405 of issuance costs. In November 2004, the Company closed another follow-on public offering, pursuant to which it sold 1,380 shares of common stock, withproceeds to the Company of approximately $75,207, net of $215 of issuance costs. Concurrently in November 2004, the Company issuedconvertible senior notes pursuant to which it received $116,199, net of $3,801 of initial purchaser's discount and debt issuance costs.4. MARKETABLE SECURITIES The Company's marketable securities consist of funds deposited into capital management accounts managed by two financial institutions.The financial institutions invested these funds in municipal, government, and corporate bonds at December 31, 2003, as follows: Cost Basis UnrealizedGains UnrealizedLosses EstimatedMarket ValueU.S. government and government agency securities $9,299 $1 $(7)$9,293Corporate securities 296 — — 296Money market securities 748 1 — 749Mortgage based securities 1,169 — (7) 1,162 $11,512 $2 $(14)$11,500 The financial institutions have invested these funds in municipal, government, and corporate bonds at December 31, 2004, as follows: Cost Basis UnrealizedGains UnrealizedLosses EstimatedMarket ValueU.S. government and government agency securities $27,225 $45 $(117)$27,153Corporate securities 55,197 — (17) 55,180Mortgage based securities 6,483 — (14) 6,469 $88,905 $45 $(148)$88,802 All marketable securities mature between 2005 and 2045.F-16 The components of realized gains and losses on sales of marketable securities for the years ended December 31, 2002, 2003 and 2004were: Year ended December 31, 2002 2003 2004Gross gains $— $19 $2Gross losses (55) (4) — Net realized gain (loss) on sales of marketable securities $(55)$15 $2 5. INVENTORIES Inventories consist of the following: December 31, 2003 2004 Product inventory $31,064 $46,602 Less: allowance for obsolescence (1,138) (1,323) $29,926 $45,279 6. PROPERTY AND EQUIPMENT Property and equipment consists of the following: December 31, 2003 2004 Computer hardware and software $9,249 $16,717 Furniture and equipment 6,738 8,128 Leasehold improvements 146 231 16,133 25,076 Less: accumulated depreciation and amortization (6,650) (8,954) $9,483 $16,122 Depreciation and amortization of property and equipment totaled $1,842, $2,289, and $3,876 for the years ended December 31, 2002, 2003and 2004, respectively. Property and equipment included assets under capital leases of $976 and $2,810 at December 31, 2003 and 2004, respectively andaccumulated amortization related to assets under capital leases of $824 and $1,330, respectively.F-17 7. OTHER LONG-TERM ASSETS Other long-term assets consist of the following: December 31, 2003 2004 Domain names $323 $323 Less: accumulated amortization (116) (177) 207 146 Deferred financing fees, net — 206 Deposits and long-term prepaids 220 1,164 $427 $1,516 Amortization of domain names totaled $31, $36 and $61 for the years ended December 31, 2002, 2003 and 2004, respectively.8. ACCRUED LIABILITIES Accrued liabilities consist of the following: December 31, 2003 2004Inventory received but not invoiced $1,126 $6,593Reserve for returns 1,110 2,835Accrued payroll and other related costs 850 3,289Deferred revenue — 1,048Accrued marketing expenses 2,674 5,236Merchant processing fee accrual 1,313 643Accrued freight 661 506Other accrued expenses 1,582 2,767 $9,316 $22,917 9. BORROWINGS In May 2004, the Company entered into a senior secured credit facility for a revolving line of credit of up to the lesser of (i) $20,000, (ii) 60%of eligible inventory, or (iii) 80% times the net liquidation percentage minus the sum of (i) the bank product reserve, and (ii) the aggregate amountof reserves, if any, all as defined in the agreement. The borrowings were collateralized by the assets of the Company and bore interest at aminimum of 3.5% using the Wells Fargo base rate as defined in the agreement, or, at the option of the Company, based on the LIBOR rate. Thecredit facility was terminated by the Company in December 2004. In December 2004, the Company replaced the senior secured credit facility described above with an amendment to a credit agreement("Amended Credit Agreement") with Wells Fargo Bank, National Association. The existing credit agreement (originally executed in February 2004)provided the Company with a revolving line of credit for the purpose of issuing up to $10,000 of letters of credit forF-18 the purchase of inventory. The Amended Credit Agreement provides a revolving line of credit to the Company of up to $30,000 and expiresDecember 31, 2005. The Company has an option to renew the Amended Credit Agreement annually. Included in the $30,000 Amended CreditAgreement is a $10,000 sub-limit for a revolving line of credit which the Company uses to obtain letters of credit to support inventory purchases.At December 31, 2004 the issuing bank or an affiliate of the bank had letters of credit totaling $8,225 issued on our behalf under this facility.However, the Company has no liability for this amount except to the extent, if any, that a beneficiary of any of the outstanding letters of creditdraws upon a letter of credit. Interest on borrowings is payable monthly and accrues at either (i) one-half of one percentage point (0.50%) above LIBOR in effect on thefirst day of an applicable fixed rate term, or (ii) at a fluctuating rate per annum determined by the bank to be one half a percent (0.50%) above dailyLIBOR in effect on each business day a change in daily LIBOR is announced by the bank. Unpaid principal, together with accrued and unpaidinterest is due on the maturity date, December 31, 2005. Borrowings under the facility are collateralized by the Company's cash and marketablesecurities deposited at Wells Fargo or its affiliates, and the Company is required to maintain balances with Wells Fargo or its affiliates of up to$37.0 million in order to have the full amount of the credit facility available. At December 31, 2004, there was no outstanding balance on this line. The Amended Credit Agreement requires the Company to comply with certain covenants, including restrictions on mergers, businesscombinations or transfer of assets. The Company was in compliance with these covenants at December 31, 2004.Capital leases Future minimum lease payments under capital leases are as follows:Year EndingDecember 31, 2005 $632 2006 613 2007 168 2008 7 Thereafter — Total minimum lease payments 1,420 Less: amount representing interest (82) Present value of capital lease obligations 1,338 Less: current portion (595) Capital lease obligations, non-current $743 10. 3.75% CONVERTIBLE SENIOR NOTES In November 2004, the Company completed an offering of $120,000 of 3.75% Convertible Senior Notes (the "Senior Notes"). This includes$20,000 of additional Senior Notes issued to the initialF-19 purchaser upon exercise of its 30-day purchase option to cover over-allotments. Proceeds to the Company were $116,199, net of $3,801 of initialpurchaser's discount and debt issuance costs. The discount and debt issuance costs are being amortized using the straight-line method whichapproximates the interest method. During 2004, the Company recorded amortization of discount and debt issuance costs related to this offeringtotaling $52. Interest on the Senior Notes is payable semi-annually on June 1 and December 1 of each year, beginning June 1, 2005. The SeniorNotes mature on December 1, 2011 and are unsecured and rank equally in right of payment with all existing and future unsecured, unsubordinateddebt and senior in right of payment to any existing and future subordinated indebtedness. The Senior Notes are convertible at any time prior to maturity into the Company's common stock at the option of the note holders at aconversion price of $76.23 per share or approximately 1,574 shares in aggregate (subject to adjustment in certain events, including stock splits,dividends and other distributions and certain repurchases of the Company's stock, as well as certain fundamental changes in the ownership of theCompany). Beginning December 1, 2009, the Company has the right to redeem the Senior Notes, in whole or in part, for cash at 100% of theprincipal amount plus accrued and unpaid interest. Upon the occurrence of a fundamental change (including the acquisition of a majority interest inthe Company, certain changes in the Company's board of directors or the termination of trading of the Company's stock) meeting certainconditions, holders of the Senior Notes may require the Company to repurchase for cash all or part of their notes at 100% of the principal amountplus accrued and unpaid interest. The indenture governing the Senior Notes requires the Company to comply with certain affirmative covenants, including making principal andinterest payments when due, maintaining our corporate existence and properties, and paying taxes and other claims in a timely manner. TheCompany was in compliance with these covenants at December 31, 2004.11. COMMITMENTS AND CONTINGENCIES The Company leases 43 square feet of office space under an operating lease which was originally scheduled to expire in January 2007.However, this lease will be terminated and replaced with a lease agreement the Company entered into in December 2004 for a new office buildingin the Old Mill Corporate Center III in Salt Lake City, Utah. Pursuant to this agreement, the Company will lease approximately 143 rentable squarefeet for a term of 10 years beginning when the Company occupies the premises, which the Company expects to be in the summer of 2005 whenconstruction is completed. On February 11, 2005, the Company and Old Mill Corporate Center III, LLC (the "Lessor") entered into a TenantImprovement Agreement (the "OMIII Agreement") relating to the office building. The OMIII Agreement sets forth the terms on which the Companywill pay the costs of certain improvements to the leased office space. The amount of the costs is estimated to be approximately $2,000. TheOMIII Agreement requires the Company to reimburse the Lessor for the amount of the costs within 30 days after presentation of invoices or writtenrequests for reimbursement. The OMIII Agreement also requires the Company to provide either a cash deposit or a letter of credit in the amount of$500 to the Lessor to provide funds for the removal of the improvements upon the termination of the lease.F-20 The Company also leases 354 square feet for its warehouse facility in Salt Lake City, Utah under an operating lease which expires inAugust 2012. Minimum future payments under these leases are as follows:Year EndingDecember 31, 2005 $4,0992006 5,2642007 4,9582008 4,9452009 5,078Thereafter 26,321 $50,665 Rental expense for operating leases totaled $1,639, $1,955 and $1,933 for the years ended December 31, 2002, 2003 and 2004, respectively. The Company is involved in various legal matters arising in the normal course of business. In the opinion of management, the Company'sliability, if any, arising from regulatory matters and legal proceedings related to these matters is not expected to have a material adverse impact onthe Company's financial position, results of operations and cash flows. The outcomes of legal matters in which the Company is presently involvedare not probable and reasonably estimable. In October 2003, Tiffany (NJ) Inc. and Tiffany and Company filed a complaint against the Company in the United States District Court for theSouthern District of New York alleging that the Company has distributed counterfeit and otherwise unauthorized Tiffany product in violation offederal copyright and trademark law and related state laws. The complaint seeks statutory and other damages in an unspecified amount andinjunctive relief. In January 2005, Tiffany (NJ) Inc. and Tiffany and Company filed four additional complaints against the Company in the UnitedStates District Court for the Southern District of New York alleging that the Company has distributed counterfeit and otherwise unauthorized Tiffanyproduct in violation of federal copyright and trademark law and related state laws. These complaints also seek statutory and other damages in anunspecified amount and injunctive relief. Although the Company has filed answers to these complaints and believes it has defenses to theallegations and intends to pursue them vigorously, the Company does not have sufficient information to assess the validity of the claims or theamount of potential damages alleged in these suits. In July 2004, Printmaker International, Ltd. filed a complaint against the Company in the United States District Court for the Southern Districtof New York alleging that the Company has distributed counterfeit and otherwise unauthorized product in violation of federal copyright andtrademark law and related state laws. The complaint seeks statutory and other damages in an unspecified amount and injunctive relief. Althoughthe Company has filed an answer and believes it has defenses to the allegations and intends to pursue them vigorously, the Printmaker lawsuit isin the early stages of discovery, and the Company does not have sufficient information to assess the validity of the claims or the amount ofpotential damages. The Company's fulfillment partner (who is also a defendant in theF-21 case) is conducting the defense of the case and has agreed to indemnify the Company against the claim and any judgment. In May 2004, the Company filed a complaint against TLMT Holdings, Inc (f/k/a LastMinuteTravel.com, Inc.) in the Superior Court of the Stateof Delaware alleging that it breached its contract with the Company. In July 2004, TLMT Holdings filed a counterclaim against the Companyalleging that the Company has breached the contract. The counterclaim seeks damages in an unspecified amount. The Company has filed ananswer to the counterclaim and believes it has defenses to the allegations and intends to pursue them vigorously. At this point in time, theCompany does not have sufficient information to assess the validity of the claims or the amount of potential damages. In January 2003, the Company received a letter from NCR Corporation claiming that certain of the Company's business practices andinformation technology systems infringe patents owned by NCR. The letter further stated that NCR would vigorously protect its intellectual propertyrights if the Company does not agree to enter into licensing arrangements with respect to the asserted patents. On January 31, 2003, theCompany filed a complaint in the United States District Court of Utah, Central Division seeking declaratory judgment that the Company does notinfringe any valid claim of the patents asserted by NCR. On March 24, 2003, NCR filed an answer and counterclaims alleging that certain of theCompany's business practices and information technology systems infringe patents owned by NCR. On April 8, 2003, the Company filed ananswer denying the material allegations in NCR's counterclaims. On May 12, 2003, the parties entered into a standstill agreement, agreeing to thedismissal of the complaint and counterclaims without prejudice to either party's ability to renew its claims at a later date. On May 19, 2003, thecourt entered an order dismissing the complaint and counterclaims without prejudice. The parties each reserved all claims and counterclaims. InAugust 2004, NCR notified the Company of its intent to terminate the standstill agreement. On September 2, 2004, the Company re-filed itscomplaint in the United States District Court of Utah, Central Division seeking declaratory judgment that the Company does not infringe any validclaim of the patents asserted by NCR. On October 4, 2004, NCR filed an answer and counterclaims alleging that certain of the Company'sbusiness practices and information technology systems infringe patents owned by NCR. On October 12, 2004, the Company filed an answerdenying the material allegations in NCR's counterclaims. Although the Company has filed an answer and believes it has defenses to theallegations and intends to pursue them vigorously, the NCR lawsuit is not yet even in the early stages of discovery, and the Company does nothave sufficient information to assess the validity of the claims or the amount of potential damages. In September 2004, the Company received a letter from BTG International Inc. claiming that certain of the Company's business practices andonline marketing information technology systems infringe patents owned by BTG. On September 14, 2004, without engaging in any meaningfuldiscussion or negotiation with the Company, BTG filed a complaint in the United States District Court of Delaware alleging that certain of theCompany's business practices and online marketing information technology systems infringe a single patent owned by BTG. On October 21, 2004,the Company filed an answer denying the material allegations in BTG's claims. Although the Company has filed an answer and believes it hasdefenses to the allegations and intends to pursue them vigorously, the BTG lawsuit is not yet even in the early stages of discovery, and theCompany does not have sufficient information to assess the validity of the claims or the amount of potential damages.F-22 12. REDEEMABLE SECURITIES In March 2002, the Company sold approximately 959 shares of mandatorily redeemable convertible preferred stock ("preferred stock") forapproximately $6,582, net of issuance costs. The preferred stock automatically converted to common stock on a 1:1 basis in connection with theinitial public offering. As the fair value of the common stock to be received upon conversion was greater than the conversion price of the preferredstock at the date the preferred stock was issued, a beneficial conversion feature resulted in the amount of $6,607, which was calculated inaccordance with Emerging Issues Task Force No. 98-5 Accounting for Convertible Securities with Beneficial Conversion Features or ContingentlyAdjustable Conversion Ratios. This beneficial conversion feature was reflected as a deemed dividend in the statement of operations during theyear ended December 31, 2002. Redeemable common stock relates to warrants and securities that are subject to rescission. Sales of 858 shares of the common stock andthe issuance of 185 warrants to certain individuals did not fully comply with certain requirements under applicable State Blue Sky Laws. The offerand sale of these securities were not made pursuant to a registration statement and the Securities Act of 1933, nor were the offer and saleregistered or qualified under any state security laws. Although the Company believed at the time that such offers, sales and conversion wereexempt from such registration or qualification, they may not have been exempt in several states. As a result, purchasers of our common stock insome states have the right under federal or state securities laws to rescind their purchases for an amount equal to the purchase price paid for theshares, plus interest from the date of purchase until the rescission offer expires, at the annual rate mandated by the state in which such shareswere purchased. These interest rates range from 8% to 10% per annum. The rescission rights lapse on various dates through September 2006. AtDecember 31, 2004, there were 460 shares of common stock and 112 warrants subject to rescission rights outstanding. At December 31, 2003 and 2004, the Company has classified $2,978 and $3,166, respectively, related to the rescission rights outside ofshareholders' equity, because the redemption features are not within the control of the Company. However, management does not anticipate thatholders of the redeemable common stock will exercise their rescission rights. Interest attributable to these securities is recorded as a deemeddividend and reflected as a deduction from net loss to arrive at net loss attributable to common shares in the Statements of Operations.13. STOCKHOLDERS' EQUITYReincorporation In May 2002, the Company reincorporated in Delaware. As a result of the reincorporation, the Company is authorized to issue 100,000 sharesof $0.0001 par value common stock and 5,000 shares of $0.0001 par value preferred stock. The Board of Directors may issue the undesignatedpreferred stock in one or more series and determine preferences, privileges and restrictions thereof.Common Stock Each share of common stock has the right to one vote. The holders of common stock are also entitled to receive dividends whenever fundsare legally available and when declared by the Board of Directors, subject to prior rights of holders of all classes of stock outstanding havingpriority rights as to dividends. No dividends have been declared or paid on the Company's common stock through December 31, 2004.F-23 Warrants In 2000, the Company issued warrants to certain shareholders in connection with the purchase of additional shares of common stock. AtDecember 31, 2004, warrants to purchase 887 shares of common stock of the Company were outstanding, as follows:Issuance Date ExercisePriceper Share WarrantsOutstanding ExpirationDateMay 1, 2000 $7.09 163 April 30, 2005May 15, 2000 $7.09 231 May 14, 2005June 22, 2000 $7.09 7 June 21, 2005September 21, 2000 $4.26 486 September 20, 2005 The number of warrants exercised in 2002, 2003 and 2004 were 3, 50 and 182, respectively. As of December 31, 2004, the Company has reserved sufficient shares of common stock to meet its stock option and warrant obligations.As stated in Note 12, 112 of these warrants are subject to rescission. At December 31, 2003 and 2004, related parties held 850 of the totalwarrants outstanding.14. STOCK OPTION PLANS The Company's board of directors adopted the Amended and Restated 1999 Stock Option Plan and the 2002 Stock Option Plan (collectively,the "Plans"), in May 1999 and April 2002, respectively. Under these Plans, the Board of Directors may issue incentive stock options to employeesand directors of the Company and non-qualified stock options to consultants of the Company. Options granted under these Plans generally expireat the end of five years and vest in accordance with a vesting schedule determined by the Company's Board of Directors, usually over four yearsfrom the grant date. As of the initial public offering, the Amended and Restated 1999 Stock Option Plan was terminated. Future shares will begranted under the 2002 Stock Option Plan. As of December 31, 2004, 1,184 shares are available for future grants under these Plans. The following is a summary of stock option activity: 2002 2003 2004 Shares WeightedAverageExercisePrice WeightedAverage FairValue Shares WeightedAverageExercisePrice Shares WeightedAverageExercisePriceOutstanding—beginning of year 1,161 $4.68 1,415 $5.37 1,780 $8.39 Granted at fair value 245 8.05 854 12.77 474 24.14 Granted at price below fair value 543 5.07 $9.61 — — — — Exercised (146) 4.22 (197) 4.69 (468) 6.75 Canceled/forfeited (388) 5.15 (292) 9.12 (274) 13.26 Outstanding—end of year 1,415 5.37 1,780 8.39 1,512 12.90 Options exercisable at year-end 388 4.93 614 5.44 608 7.51F-24 The following table summarizes information about stock options as of December 31, 2004: Options Outstanding atDecember 31, 2004 Options Exercisable atDecember 31, 2004Range of Exercise Prices Shares WeightedAverageExercisePrice WeightedAverageRemainingContract Life Shares WeightedAverageExercisePrice$ 2.00-$4.99 114 $4.05 2.4 63 $3.87$ 5.00-$6.99 419 5.07 1.8 320 5.07$ 7.00-$11.99 146 9.55 2.4 94 9.64$12.00-$17.99 401 13.29 3.5 128 13.31$18.00-$53.45 432 23.60 4.2 3 34.06 1,512 12.90 3.0 608 7.51 The weighted-average grant-date fair value of options granted during 2002, 2003 and 2004 was $8.21, $8.27 and $15.39 per share,respectively. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the followingweighted-average assumptions: 2002 2003 2004 Risk-free interest rate 3.31%2.63%2.61%Expected life (in years) 3 3 3 Volatility 100%104%101%Expected dividend yield 0%0%0%Stock-based compensation In connection with certain stock option grants to employees during the year ended December 31, 2002 the Company recognizedapproximately $3,481 of unearned stock-based compensation for the excess of deemed fair value of shares of common stock subject to suchoptions over the exercise price of these options at the date of grant. In 2003 and 2004, the company reversed $478 and $198, respectively, ofunearned stock-based compensation due to forfeitures of unvested options. Such amounts are included as a component of stockholders' equityand are being amortized over the vesting period in accordance with FASB Interpretation Number 28, Accounting for Stock Appreciation Rights andOther Variable Stock Option or Award Plan. The Company recorded stock-based compensation expense of $3,276, $846 and $360 during theyears ended December 31, 2002, 2003 and 2004, respectively. During the years ended December 31, 2002, 2003 and 2004, the Company granted 177, 18 and 25 options to consultants, respectively. TheCompany recorded unearned stock-based compensation of $131, $268 and $2,043 related to these grants, of which $24, $177 and $1,278 wasrecognized in operations in 2002, 2003 and 2004, respectively. The fair value for these options was measured at the grant date and is remeasuredat the end of each quarter until vesting is complete. At December 31, 2002, 2003 and 2004, the fair value of these options was calculated using aBlack-Scholes option pricing model using risk-free rates of 3.31%, 2.59% and 3.45%, respectively, an expected life of 3 years, expected volatilityof 100%, 105% and 96%, respectively, and a dividend yield of 0%.F-25 15. EMPLOYEE STOCK PURCHASE PLAN Effective January 24, 2001, the Company adopted an Employee Stock Purchase Plan (the "ESPP") to provide certain employees, directorsand consultants an opportunity to purchase shares of its common stock annually, up to 5% of eligible compensation. During a specified openperiod as determined the Board of Directors, participants can purchase shares of stock at a value determined by the Company's board of directorswhich approximates the deemed fair market value of the stock. As of the initial public offering, the ESPP was terminated. There were 14 and 6shares issued under the ESPP during 2001 and 2002, respectively and no shares during 2003 and 2004. The Company recognized approximately$51 of stock-based compensation for the excess of the fair value of the shares of common stock over the purchase price during 2002.16. EMPLOYEE RETIREMENT PLAN The Company has a 401(k) defined contribution plan which permits participating employees to defer up to a maximum of 25% of theircompensation, subject to limitations established by the Internal Revenue Code. Employees who have completed a half-year of service and are21 years of age or older are qualified to participate in the plan. The Company matches 50% of the first 6% of each participant's contributions to theplan. Participant contributions are immediately vested. Company contributions vest based on the participant's years of service at 20% per yearover five years. The Company's cash contribution totaled $88, $99 and $124 during 2002, 2003 and 2004, respectively.17. INCOME TAXES The components of the Company's deferred tax assets and liabilities as of December 31, 2003 and 2004 are as follows: December 31, 2003 2004 Deferred tax assets: Net operating loss carryforwards $24,072 $26,121 Accrued expenses 1,371 3,146 Reserves and other 1,208 1,854 26,651 31,121 Deferred tax liabilities: Depreciation (986) (2,597)Valuation allowance (25,665) (28,524) Net asset $— $— As a result of the Company's history of losses, a valuation allowance has been provided for the full amount of the Company's net deferredtax assets. In management's opinion, it is more likely than not that such benefits will not be realized. At December 31, 2003 and 2004, the Company had net operating loss carryforwards of approximately $48,018 and $53,330, respectively,which may be used to offset future taxable income. An additional $14,386 of net operating losses are limited under Internal Revenue CodeSection 382 to $799 a year. These carryforwards begin to expire in 2019.F-26 The income tax benefit differs from the amount computed by applying the U.S. federal income tax rate of 35% to loss before income taxesfor the following reasons: Year ended December 31, 2002 2003 2004 U.S. federal income tax benefit at statutory rate $1,596 $4,166 $1,751 State income tax benefit, net of federal expense 38 385 164 Stock compensation expense (1,216) (384) (127)Other (611) (71) 1,071 Unrecognized benefit due to valuation allowance 193 (4,096) (2,859) Income tax benefit $— $— $— 18. RELATED PARTY TRANSACTIONS As indicated in Note 12, the Company sold shares of mandatorily redeemable convertible preferred stock in March 2002, for which a deemeddividend was recorded as a result of the beneficial conversion feature. The total deemed dividend recorded for the year ended December 31, 2002was $6,607, of which $1,000 is attributable to preferred shares purchased by Haverford Internet, $1,200 is attributable to preferred sharespurchased by members of the board of directors, and $1,500 is attributable to preferred shares purchased by family members of management. On occasion, Haverford-Valley, L.C. (an entity owned by the Company's president) and certain affiliated entities make travel arrangements forour executives and pay the travel related expenses incurred by our executives on Company business. In 2002, 2003, and 2004 we reimbursedHaverford-Valley L.C. $273, $236, and $256, respectively, for these expenses.19. BUSINESS SEGMENTS Segment information has been prepared in accordance with SFAS No. 131, Disclosures about Segments of an Enterprise and RelatedInformation. Segments were determined based on products and services provided by each segment. Accounting policies of the segments are thesame as those described in Note 2. There were no intersegment sales or transfers during 2002, 2003 or 2004. The CompanyF-27 evaluates the performance of its segments and allocates resources to them based primarily on gross profit. The table below summarizesinformation about reportable segments. Direct Fulfillmentpartner Consolidated 2002 Revenue $79,405 $12,379 $91,784 Cost of goods sold 70,686 2,755 73,441 Gross profit (loss) 8,719 9,624 18,343 Operating expenses (22,397)Other income, net (506) Net loss $(4,560) 2003 Revenue $138,134 $100,811 $238,945 Cost of goods sold 124,302 89,190 213,492 Gross profit 13,832 11,621 25,453 Operating expenses (37,840)Other income, net 500 Net loss $(11,887) 2004 Revenue $213,210 $281,425 $494,635 Cost of goods sold 185,390 243,468 428,858 Gross profit 27,820 37,957 65,777 Operating expenses (71,128)Other income, net 349 Net loss $(5,002) The direct segment includes revenues, direct costs, and allocations associated with sales fulfilled from our warehouse. Costs for thissegment include product costs, inbound freight, warehousing, and fulfillment costs, credit card fees and customer service costs. The fulfillment partner segment includes revenues, direct costs and cost allocations associated with the Company's third party fulfillmentpartner sales and are earned from selling the merchandise of third parties over the Company's Websites. Prior to July 1, 2003, this was reported asthe "commission revenue" segment, as only the commission portion of the sales transactions were recorded as revenue (i.e., recorded "net"). Thecosts for the previous commission segment only included credit card fees and customer service costs. From July 1, 2003 forward, due to achange in the company's business practices, including the partner sales return process, these sales transactions are now recorded gross. As aresult, this segment's name has been changed to the "fulfillment partner" segment, and the costs for this segment include product costs,warehousing and fulfillment costs, credit card fees and customer service costs. Assets have not been allocated between the segments for management purposes, and as such, they are not presented here.F-28 In 2002, 2003 and 2004, over 99% of sales were made to customers in the United States of America. No individual geographical areaaccounted for more than 10% of net sales in any of the periods presented. At December 31, 2003 and 2004, all of the Company's fixed assetswere located in the United States of America.20. VARIABLE INTEREST ENTITY In August 2004, the Company entered into an agreement which allows the Company to lend up to $10,000 to an entity for the purpose ofbuying inventory, primarily to supply a new category within our jewelry store which allows customers purchasing diamond rings to select both aspecific diamond and ring setting. In November 2004, the Company loaned the entity $8,400. The promissory note bears interest at 3.75% perannum. The Company will also receive fifty percent (50%) of any profits of the entity. Interest shall be due and payable quarterly on the fifteenthday of February, May, August and November, commencing on November 15, 2004 until the due date of November 30, 2006, on which all principaland interest accrued and unpaid thereon, shall be due and payable. The promissory note is collateralized by all of the assets of the entity. The Company has a ten year option to purchase ("Purchase Option") 50% of the ownership and voting interest of the entity. The exerciseprice of the Purchase Option is the sum of (a) one thousand dollars, and (b) $3.0 million, which may be paid, at the Company's election, in cash orby the forgiveness of $3.0 million of the entity's indebtedness to the Company. The entity was evaluated in accordance with FASB Interpretation No. 46 Revised, Consolidation of Variable Interest Entities—anInterpretation of ARB No. 51, and it was determined to be a variable interest entity for which the Company was determined to be the primarybeneficiary. As such, the financial statements of the entity are consolidated into the financial statements of the Company. The carrying amount and classification of the consolidated assets that are collateral for the entity's obligations include: December 31,2004Cash $979Accounts receivable 12Inventory 7,325Prepaid expenses 75Property and equipment 224 $8,615 21. SHARE BUY BACK PROGRAM During January 2005, the Company's Board of Directors authorized a stock buyback program under which the Company is authorized torepurchase up to $50,000 of its common stock through December 31, 2007. In February and March 2005 the Company entered into several purchased call options, pursuant to which the Company may purchase up to1,250 shares of its common stock at certain settlement dates. In connection with these repurchase transactions, the Company has paidapproximately $47,507. UponF-29 settlement, the Company, at its option, may elect to settle the contracts by physical settlement, net share settlement or net cash settlement.Accordingly, we expect to receive either our capital investment returned with a premium or shares of our common stock, depending on whether themarket price of the Company's common stock is above or below a pre-determined price agreed in connection with each such transaction. To the extent that shares of common stock are delivered to the Company as a result of the transactions described above, the aggregateamount the Company pays or paid for the repurchase of the shares as a result of these transactions will reduce the amount the Company mightotherwise have spent to directly repurchase shares from time to time under its stock repurchase program.22. QUARTERLY RESULTS OF OPERATIONS (unaudited) The following tables set forth our unaudited quarterly results of operations data for the eight most recent quarters for the period endedDecember 31, 2004. We have prepared this information on the same basis as the Consolidated Statements of Operations and the informationincludes all adjustments, consisting only of normal recurring adjustments, that we consider necessary for a fair statement of our financial positionand operating results for the quarters presented. Three Months Ended Mar. 31,2003 June 30,2003 Sept. 30,2003 Dec. 31,2003 Mar. 31,2004 June 30,2004 Sept. 30,2004 Dec. 31,2004 (in thousands, except per share data) Consolidated Statement of Operations Data: Revenue Direct revenue $25,198 $25,402 $29,284 $58,250 $38,580 $41,113 $43,928 $89,589 Fulfillment partner revenue 3,966 3,431 28,504 64,910 43,498 46,679 59,516 131,732 Total revenue 29,164 28,833 57,788 123,160 82,078 87,792 103,444 221,321 Cost of goods sold Direct 23,484 23,014 26,674 51,130 34,816 36,786 38,594 75,194 Fulfillment partner 1,055 1,016 26,863 60,256 38,793 41,114 51,103 112,458 Total cost of goods sold 24,539 24,030 53,537 111,386 73,609 77,900 89,697 187,652 Gross profit 4,625 4,803 4,251 11,774 8,469 9,892 13,747 33,669 Operating expenses: Sales and marketing expenses 3,848 2,572 3,855 9,898 4,377 6,605 9,398 20,153 General and administrative expenses 4,545 3,367 4,059 4,940 6,251 5,567 7,376 11,041 Amortization of stock-based compensation 328 112 171 145 135 123 18 84 Total operating expenses 8,721 6,051 8,085 14,983 10,763 12,295 16,792 31,278 Operating income (loss) (4,096) (1,248) (3,834) (3,209) (2,294) (2,403) (3,045) 2,391 Interest income 152 142 98 69 98 127 168 780 Interest expense (7) (55) (8) (6) (16) (46) (77) (636)Other income (expense), net 10 25 79 1 2 — 3 (54) Net income (loss) (3,941) (1,136) (3,665) (3,145) (2,210) (2,322) (2,951) 2,481 Deemed dividend related to redeemable commonstock (77) (78) (58) (49) (48) (46) (47) (47)Net income (loss) attributable to common shares $(4,018)$(1,214)$(3,723)$(3,194)$(2,258)$(2,368)$(2,998)$2,434 Net income (loss) per common share —basic $(0.26)$(0.07)$(0.23)$(0.19)$(0.14)$(0.13)$(0.16)$0.13 —diluted $(0.26)$(0.07)$(0.23)$(0.19)$(0.14)$(0.13)$(0.16)$0.12 Weighted average common shares outstanding —basic 15,486 16,384 16,419 16,473 16,646 17,577 18,284 19,016 —diluted 15,486 16,384 16,419 16,473 16,646 17,577 18,284 20,780 F-30 Schedule IIValuation and Qualifying Accounts(dollars in thousands) Balance atBeginning of Year Charged toExpense Deductions Balance atEnd of YearYear ended December 31, 2002 Deferred tax valuation allowance $21,762 $— $193 $21,569 Reserve for sales returns 496 3,994 4,025 465 Allowance for inventory obsolescence 943 164 96 1,011 Allowance for doubtful accounts — 145 — 145Year ended December 31, 2003 Deferred tax valuation allowance $21,569 $4,096 $— $25,665 Reserve for sales returns 465 11,463 10,818 1,110 Allowance for inventory obsolescence 1,011 1,763 1,636 1,138 Allowance for doubtful accounts 145 529 24 650Year ended December 31, 2004 Deferred tax valuation allowance $25,665 $2,859 $— $28,524 Reserve for sales returns 1,110 36,975 35,250 2,835 Allowance for inventory obsolescence 1,138 1,008 823 1,323 Allowance for doubtful accounts 650 976 876 750F-31 QuickLinks -- Click here to rapidly navigate through this documentExhibit 10.34$100,000,000OVERSTOCK.COM, INC.3.75% Convertible Senior Notes due 2011 PURCHASE AGREEMENT November 17, 2004LEHMAN BROTHERS INC.As Representative of the Initial Purchasers c/o LEHMAN BROTHERS INC.745 Seventh AvenueNew York, NY 10019Ladies and Gentlemen: Overstock.com, Inc., a Delaware corporation (the "Company"), proposes, upon the terms and conditions set forth herein, to issue and sell toLehman Brothers Inc. and the other initial purchasers identified in Schedule 1 hereto (together, the "Initial Purchasers"), for whom LehmanBrothers Inc. is acting as representative (the "Representative"), $100,000,000 in aggregate principal amount of its 3.75% Convertible Senior Notesdue 2011 (the "Firm Notes"). In addition, the Company proposes to grant to the Initial Purchasers an option (the "Option") to purchase up to anadditional $20,000,000 in aggregate principal amount of Convertible Senior Notes due 2011 (the "Optional Notes" and, together with the FirmNotes, the "Notes"). The Notes will (i) have terms and provisions which are summarized in the Offering Memorandum (as defined below) and (ii) beissued pursuant to an indenture (the "Indenture") to be entered into between the Company and Wells Fargo Bank, National Association, as trustee(the "Trustee"). Pursuant to and as set forth in the Indenture, each $1,000 principal amount of Notes shall be convertible into common stock of theCompany, par value $0.0001 (the "Common Stock"), on the terms, and subject to the conditions, set forth in the Indenture. As used herein,"Conversion Shares" means the shares of Common Stock into which the Notes are convertible. The Notes will be offered and sold to the Initial Purchasers without registration under the Securities Act of 1933, as amended (the "Act"), inreliance on an exemption pursuant to Section 4(2) under the Act. The Company has prepared a preliminary offering memorandum, datedNovember 12, 2004 (the "Preliminary Offering Memorandum"), and an offering memorandum, dated November 17, 2004 (the "OfferingMemorandum"), setting forth information regarding the Company and the Notes. Any references herein to the Preliminary Offering Memorandumand the Offering Memorandum shall be deemed to include all amendments and supplements thereto and all information incorporated by referencetherein. The Company hereby confirms that it has authorized the use of the Preliminary Offering Memorandum and the Offering Memorandum inconnection with the offering and resale of the Notes by the Initial Purchasers. You have advised the Company that you will make offers (the "Exempt Resales") of the Notes purchased by you hereunder on the terms setforth in the Offering Memorandum only to persons you reasonably believe to be qualified institutional buyers as defined in Rule 144A under the Act(each, a "Qualified Institutional Buyer") in reliance on Rule 144A under the Act. You will offer the Notes initially at a price equal to 100% of theprincipal amount thereof. You may change such price at any time without notice. Holders of the Notes (including the Initial Purchasers and their direct and indirect transferees) will be entitled to the benefits of a RegistrationRights Agreement, dated as of the First Delivery Date (as defined herein), between the Company and the Representative (the "Registration RightsAgreement"), pursuant to which the Company will agree to file with the Securities and Exchange Commission (the "Commission") one or moreshelf registration statements pursuant to Rule 415 under the Act (each a "Registration Statement") covering the resale of the Notes and theConversion Shares, and to use its commercially reasonable efforts to cause the Registration Statement to be declared effective. This Agreement, the Indenture, the Notes and the Registration Rights Agreement are referred to herein collectively as the "OperativeDocuments." 1. Representations, Warranties and Agreements of the Company. The Company represents, warrants and agrees that: (a) Since the date as of which information is given in the Preliminary Offering Memorandum, there has been no material adverse change inthe general affairs, management, financial condition, results of operations, stockholders' equity, cash flow, business or prospects of the Companyand its subsidiaries, taken as a whole, whether or not arising in the ordinary course of business (a "Material Adverse Effect"). (b) When the Notes are issued and delivered pursuant to this Agreement, they will not be deemed to be, for purposes of Rule 144A, of thesame class (within the meaning of Rule 144A under the Act) as securities of the Company that are listed on a national securities exchangeregistered under Section 6 of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), or that are quoted in a United Statesautomated inter-dealer quotation system. (c) Assuming the accuracy of the representations and warranties of the Initial Purchasers contained in Section 6 and their compliance withthe agreements set forth therein, it is not necessary, in connection with the issuance and sale of the Notes to the Initial Purchasers and the offer,resale and delivery of the Notes by the Initial Purchasers in the manner contemplated by this Agreement, the Indenture, the Registration RightsAgreement and the Offering Memorandum, to register the Notes or the Conversion Shares under the Act or to qualify the Indenture under the TrustIndenture Act of 1939, as amended (the "Trust Indenture Act"). (d) The Company is an issuer that is subject to filing requirements under Section 13 or 15(d) of the Exchange Act. (e) The Preliminary Offering Memorandum and Offering Memorandum have been prepared by the Company for use by the Initial Purchasers in connection with the Exempt Resales. No order or decree preventing the use of the Preliminary Offering Memorandum or the OfferingMemorandum, and no order asserting that the transactions contemplated by this Agreement are subject to the registration requirements of the Act,has been issued and no proceeding for that purpose has commenced or is pending or, to the knowledge of the Company, is contemplated. (f) The Preliminary Offering Memorandum and the Offering Memorandum as of their respective dates and the Offering Memorandum as ofany Delivery Date, did not and will not as of such dates contain an untrue statement of a material fact or omit to state a material fact required to bestated therein or necessary to make the statements therein, in light of the circumstances under which they were made, not misleading, except thatthis representation and warranty does not apply to statements in or omissions from the Preliminary Offering Memorandum or OfferingMemorandum made in reliance upon and in conformity with information relating to the Initial Purchasers furnished to the Company in writing by oron behalf of the Initial Purchasers expressly for use therein as specified in Section 7(e) of this Agreement. (g) The Company and each of its subsidiaries (as defined in Section 13) have been duly incorporated or organized and are validly existing ascorporations or other business entities in good standing under the laws of their respective jurisdictions of incorporation or organization, are dulyqualified to do business and are in good standing in each jurisdiction in which their respective ownership or lease of property or the conduct of theirrespective businesses requires such qualification, except where the failure to be so qualified or to be in good standing would not have a MaterialAdverse Effect, and have all power and authority necessary to own or hold their respective properties and to conduct the businesses in which theyare engaged. No such subsidiary constitutes a "significant subsidiary," as such term is defined in Rule 405 of the Rules and Regulations, of theCompany. All of the issued shares of capital stock of each corporate subsidiary of the Company have been duly and validly authorized and issuedand are fully paid and non-assessable; and all of the issued and outstanding shares of capital stock or other equity interests of each subsidiaryowned by the Company, directly or indirectly, are owned free and clear of any liens, other than those that would not have a Material AdverseEffect. (h) The Company has an authorized capitalization as set forth in the Offering Memorandum, and all of the issued shares of capital stock ofthe Company have been duly and validly authorized and issued, are fully paid and non-assessable and conform to the description thereofcontained in the Offering Memorandum; the Conversion Shares have been duly and validly authorized and reserved for issuance upon conversionof the Notes and will be free of pre-emptive rights; all Conversion Shares, when so issued and delivered upon such conversion in accordance withthe terms of the Indenture, will be duly and validly authorized and issued, fully paid and nonassessable and free and clear of all liens,encumbrances, equities or claims. (i) The Company has all necessary corporate right, power and authority to execute and deliver the Indenture and perform its obligationsthereunder; the Indenture has been duly authorized by the Company, and upon the effectiveness of the Registration Statement, will be qualifiedunder the Trust Indenture Act; on the First Delivery Date, the Indenture will have been duly executed and delivered by the Company and, assumingdue authorization, execution and delivery of the Indenture by the Trustee, will constitute a legally valid and binding agreement of the Companyenforceable in accordance with its terms; and the Indenture will conform in all material respects to the description thereof contained in the OfferingMemorandum. (j) The Company has all necessary corporate right, power and authority to execute and deliver the Registration Rights Agreement and performits obligations thereunder; the Registration Rights Agreement and the transactions contemplated thereby have been duly authorized by theCompany; when the Registration Rights Agreement is duly executed and delivered by the Company (assuming due authorization, execution anddelivery by the Representative), it will be a legally valid and binding agreement of the Company enforceable against the Company in accordancewith its terms, except with respect to the rights of indemnification and contribution thereunder, where enforcement thereof may be limited byfederal or state securities laws or the policies underlying such laws; the Registration Rights Agreement conforms in all material respects to thedescription thereof contained in the Offering Memorandum; and, except as described in the Offering Memorandum, there are no contracts,agreements or understandings between the Company and any person other than the Registration Rights Agreement that require the Company to(i) file a registration statement under the Act with respect to any securities of the Company or (ii) include such securities with the ConversionShares registered pursuant to a Registration Statement. (k) The Company has all necessary corporate right, power and authority to execute, issue and deliver the Notes and perform its obligationsthereunder; the Notes have been duly authorized by the Company; when the Notes are executed, authenticated and issued in accordance with theterms of the Indenture and delivered to and paid for by the Initial Purchasers pursuant to this Agreement on the respective Delivery Date, suchNotes will constitute legally valid and binding obligations of the Company, entitled to the benefits of the Indenture and enforceable in accordancewith their terms; and the Notes conform in all material respects to the description thereof contained in the Offering Memorandum. (l) The Company has all necessary corporate right, power and authority to execute and deliver this Agreement and perform its obligationshereunder; this Agreement has been duly authorized, executed and delivered by the Company. (m) The execution, delivery and performance of the Operative Documents by the Company, the consummation of the transactionscontemplated thereby, and the issuance and delivery of the Conversion Shares issuable upon conversion of the Notes will not conflict with orresult in a breach or violation of any of the terms or provisions of, or constitute a default under, any indenture, mortgage, deed of trust, loanagreement or other agreement or instrument to which the Company or any of its subsidiaries is a party or by which the Company or any of itssubsidiaries is bound or to which any of the property or assets of the Company or any of its subsidiaries is subject, nor will such actions result inany violation of the provisions of the charter or by-laws of the Company or any of its subsidiaries or any statute or any order, rule or regulation ofany court or governmental agency or body having jurisdiction over the Company or any of its subsidiaries or any of their properties or assets; andexcept for the registration of the Notes under the Act, the qualification of the Indenture under the Trust Indenture Act and such consents,approvals, authorizations, registrations or qualifications as may be required under the Exchange Act and applicable state law, no consent,approval, authorization or order of, or filing or registration with, any such court or governmental agency or body is required for the execution,delivery and performance of any of the Operative Documents by the Company and the consummation of the transactions contemplated therebyand the issuance of the Conversion Shares upon conversion of the Notes. (n) Except as described in the Offering Memorandum, the Company has not sold or issued any shares of Common Stock during the six-month period preceding the date of the Offering Memorandum, including any sales pursuant to Rule 144A under, or Regulation D or Regulation Sof, the Act, other than shares issued pursuant to employee benefit plans, qualified stock options plans or other employee compensation plans orpursuant to outstanding options, rights or warrants and other than the shares issued pursuant to the prospectus supplements dated May 13, 2004and November 17, 2004. (o) Neither the Company nor any of its subsidiaries has sustained, since the date of the latest audited financial statements included in the Offering Memorandum, any material loss or interference with its business from fire, explosion, flood or other calamity, whether or not covered byinsurance, or from any labor dispute or court or governmental action, order or decree, otherwise than as set forth or contemplated in the OfferingMemorandum; and, since such date, there has not been any change in the capital stock or long-term debt of the Company or any of itssubsidiaries or any Material Adverse Effect, or any development that could reasonably be expected to have a Material Adverse Effect, otherwisethan as set forth or contemplated in the Offering Memorandum. (p) The financial statements (including the related notes and supporting schedules) incorporated by reference in the Offering Memorandumpresent fairly the financial condition and results of operations of the entities purported to be shown thereby, at the dates and for the periodsindicated, and have been prepared in conformity with generally accepted accounting principles applied on a consistent basis throughout the periodsinvolved, except as otherwise disclosed therein and subject, in the case of interim financial statements, to normal year-end adjustments, none ofwhich, individually or in the aggregate, shall result in any material adverse change thereto. (q) PricewaterhouseCoopers LLP, who have certified certain financial statements of the Company, whose report is incorporated by referencein the Offering Memorandum and who have delivered the initial letter referred to in Section 5(e) hereof, is an independent registered publicaccounting firm as required by the Act and the rules and regulations promulgated thereunder. (r) Neither the Company nor its subsidiaries owns any real property. The Company and its subsidiaries have good and marketable title to allpersonal property owned by them, in each case free and clear of all liens, encumbrances and defects, except such as are described in theOffering Memorandum or such as do not materially affect the value of such property and do not materially interfere with the use made andproposed to be made of such property by the Company and its subsidiaries; and all assets held under lease by the Company and its subsidiariesare held by them under valid, subsisting and enforceable leases, with such exceptions as are not material and do not interfere with the use madeand proposed to be made of such property and buildings by the Company and its subsidiaries. (s) The Company and each of its subsidiaries carry, or are covered by, insurance in such amounts and covering such risks as the Companyconsiders adequate for the conduct of their respective businesses and the value of their respective properties and as is customary for companiesengaged in similar businesses in similar industries. (t) Except as set forth or contemplated in the Offering Memorandum, the Company and each of its subsidiaries own, or possess adequaterights to use, all material patents, patent applications, trademarks, service marks, trade names, trademark registrations, service markregistrations, copyrights and licenses (collectively, the "Intellectual Property") necessary for the conduct of their respective businesses and novalid U.S. patent is, or to the knowledge of the Company would be, infringed by the activities of the Company or any of its subsidiaries in the useor sale of any product or service as described in the Offering Memorandum. There are no actions, suits or judicial proceedings pending relating topatents or proprietary information to which the Company and each of its subsidiaries are parties or of which any property of the Company and eachof its subsidiaries is subject, and, to the knowledge of the Company, no actions, suits or judicial proceedings are threatened by governmentalauthorities, except as set forth or contemplated in the Offering Memorandum or as disclosed to the Representative in writing. The Company is notaware of, except as set forth or contemplated in the Offering Memorandum, any claim by others that the Company or any of its subsidiaries isinfringing or otherwise violating any patents or other intellectual property rights of others and is not aware of any rights of third parties to any of theCompany and its subsidiaries' patent applications, licensed patents or licenses which could affect materially the use thereof by the Company andits subsidiaries. (u) There are no legal or governmental proceedings pending to which the Company or any of its subsidiaries is a party or to which anyproperty or assets of the Company or any of its subsidiaries is the subject which, if determined adversely to the Company or any of itssubsidiaries, would reasonably be expected to have a Material Adverse Effect; and to the best of the Company's knowledge, no such proceedingsare threatened or contemplated by governmental authorities or threatened by others. (v) There are no contracts or other documents which would be required to be described in the Offering Memorandum if the OfferingMemorandum were a prospectus included in a registration statement on Form S-1 that have not been so described in the Offering Memorandum orincorporated therein by reference. (w) No relationship, direct or indirect, exists between or among the Company on the one hand, and the directors, officers, stockholders,customers or suppliers of the Company on the other hand, which would be required to be described in the Offering Memorandum if the OfferingMemorandum were a prospectus included in a registration statement on Form S-1 that have not been so described in the Offering Memorandum orincorporated therein by reference. (x) No labor disturbance by the employees of the Company or any of its subsidiaries exists or, to the knowledge of the Company, isimminent, which might be expected to have a Material Adverse Effect. (y) The Company is in compliance in all material respects with all presently applicable provisions of the Employee Retirement IncomeSecurity Act of 1974, as amended, including the regulations and published interpretations thereunder ("ERISA"); no "reportable event" (as definedin ERISA) has occurred with respect to any "pension plan" (as defined in ERISA) for which the Company would have any liability; the Companyhas not incurred and does not expect to incur liability under (i) Title IV of ERISA with respect to the termination of, or withdrawal from, any"pension plan" or (ii) Sections 412 or 4971 of the Internal Revenue Code of 1986, as amended, including the regulations and publishedinterpretations thereunder (the "Code"); and each "pension plan" for which the Company would have any liability that is intended to be qualifiedunder Section 401(a) of the Code is so qualified in all material respects and nothing has occurred, whether by action or by failure to act, whichwould cause the loss of such qualification. (z) The Company has timely and properly filed with the Commission all reports and other documents required to have been filed by it with theCommission pursuant to the Exchange Act and the rules and regulations promulgated under the Exchange Act. (aa) The Company has filed all federal, state and local income and franchise tax returns required to be filed through the date hereof and haspaid all taxes due thereon, and no tax deficiency has been determined adversely to the Company or any of its subsidiaries which has had (nordoes the Company have any knowledge of any tax deficiency which, if determined adversely to the Company or any of its subsidiaries, mighthave) a Material Adverse Effect. (bb) Since the date as of which information is given in the Preliminary Offering Memorandum through the date hereof, and except as mayotherwise be disclosed in the Offering Memorandum, the Company has not (i) issued or granted any securities (except for shares issued pursuantto outstanding options or warrants), (ii) incurred any liability or obligation, direct or contingent, other than liabilities and obligations which were incurred in the ordinary course of business, (iii) entered into any transaction not in the ordinary course of business or (iv) declared or paid anydividend on its capital stock. (cc) The Company (i) makes and keeps accurate books and records and (ii) maintains internal accounting controls which provide reasonableassurance that (A) transactions are executed in accordance with management's authorization, (B) transactions are recorded as necessary topermit preparation of its financial statements and to maintain accountability for its assets, (C) access to its assets is permitted only in accordancewith management's authorization and (D) the reported accountability for its assets is compared with existing assets at reasonable intervals. (dd) Neither the Company nor any of its subsidiaries (i) is in violation of its charter or by-laws, (ii) is in default in any material respect, and noevent has occurred which, with notice or lapse of time or both, would constitute such a default, in the due performance or observance of any term,covenant or condition contained in any material indenture, mortgage, deed of trust, loan agreement or other agreement or instrument to which it isa party or by which it is bound or to which any of its properties or assets is subject or (iii) is in violation in any material respect of any law,ordinance, governmental rule, regulation or court decree to which it or its property or assets may be subject or has failed to obtain any materiallicense, permit, certificate, franchise or other governmental authorization or permit necessary to the ownership of its property or to the conduct ofits business. (ee) Neither the Company nor any of its subsidiaries, nor any director, officer, agent, employee or other person associated with or acting onbehalf of the Company or any of its subsidiaries, has used any corporate funds for any unlawful contribution, gift, entertainment or other unlawfulexpense relating to political activity; made any direct or indirect unlawful payment to any foreign or domestic government official or employee fromcorporate funds; violated or is in violation of any provision of the Foreign Corrupt Practices Act of 1977; or made any bribe, rebate, payoff,influence payment, kickback or other unlawful payment. (ff) There has been no storage, disposal, generation, manufacture, refinement, transportation, handling or treatment of toxic wastes, medicalwastes, hazardous wastes or hazardous substances by the Company or any of its subsidiaries (or, to the knowledge of the Company, any of theirpredecessors in interest) at, upon or from any of the property now or previously owned or leased by the Company or its subsidiaries in violation ofany applicable law, ordinance, rule, regulation, order, judgment, decree or permit or which would require remedial action under any applicable law,ordinance, rule, regulation, order, judgment, decree or permit, except for any violation or remedial action which would not have, singularly or in theaggregate with all such violations and remedial actions, a Material Adverse Effect; there has been no material spill, discharge, leak, emission,injection, escape, dumping or release of any kind onto such property or into the environment surrounding such property of any toxic wastes,medical wastes, solid wastes, hazardous wastes or hazardous substances due to or caused by the Company or any of its subsidiaries or withrespect to which the Company or any of its subsidiaries have knowledge, except for any such spill, discharge, leak, emission, injection, escape,dumping or release which would not have, singularly or in the aggregate with all such spills, discharges, leaks, emissions, injections, escapes,dumpings and releases, a Material Adverse Effect. The terms "hazardous wastes," "toxic wastes," "hazardous substances" and "medical wastes"shall have the meanings specified in any applicable local, state, federal and foreign laws or regulations with respect to environmental protection. (gg) Neither the Company nor any subsidiary of the Company is, nor as of the Delivery Date will be, an "investment company" or a company"controlled" by an "investment company" within the meaning of the Investment Company Act of 1940, as amended, and the rules and regulationsof the Commission thereunder. (hh) None of the Company or any of its affiliates (as defined in Rule 501(b) of Regulation D under the Act ("Regulation D")) has, directly orthrough an agent (other than the Initial Purchasers, about which no representation is made by the Company), engaged in any form of generalsolicitation or general advertising in connection with the offering of the Notes (as those terms are used in Regulation D) under the Act or in anymanner involving a public offering within the meaning of Section 4(2) of the Act; the Company has not entered into any contractual arrangementwith respect to the distribution of the Notes except for this Agreement and the Company will not enter into any such arrangement except for theRegistration Rights Agreement. (ii) Neither the Company nor, to its knowledge, any of its affiliates has taken, directly or indirectly, any action designed to cause or result in,or which has constituted or which might reasonably be expected to constitute, the stabilization or manipulation of the price of any security of theCompany in connection with the offering of the Notes. (jj) The statistical and market-related data included in the Offering Memorandum are based on or derived from sources that the Companybelieves to be reliable and accurate in all material respects. 2. Purchase, Sale and Delivery of Notes. (a) Subject to the terms and conditions and in reliance upon the representations and warranties herein set forth, the Company agrees to sellto the Initial Purchasers, and the Initial Purchasers agree, severally and not jointly, to purchase from the Company, at a purchase price of 97% ofthe principal amount thereof (the "purchase price"), the aggregate principal amount of Firm Notes set forth opposite that Initial Purchaser's name inSchedule 1 hereto. Delivery of and payment for the Firm Notes shall be made at the office of Cleary, Gottlieb, Steen & Hamilton, One Liberty Plaza, New York,New York 10006, at 10:00 a.m. (New York time) on the fourth full business day following the date of this Agreement, or at such other date or placeas shall be determined by agreement between the Initial Purchasers and the Company (such date and time of delivery and payment for the FirmNotes being herein called the "First Delivery Date"). Delivery of the Firm Notes shall be made to the Initial Purchasers against payment of thepurchase price by the Initial Purchasers. Payment for the Firm Notes shall be effected either by wire transfer of immediately available funds to anaccount with a bank in The City of New York, the account number and the ABA number for such bank to be provided by the Company to the InitialPurchasers at least two business days in advance of the First Delivery Date, or by such other manner of payment as may be agreed by theCompany and the Initial Purchasers. (b) Subject to the terms and conditions and in reliance upon the representations and warranties herein set forth, the Company hereby grantsthe Option to the Initial Purchasers to purchase the Optional Notes at the same price as the Initial Purchasers shall pay for the Firm Notes. TheOption may be exercised at the sole discretion of the Initial Purchasers. The Option may be exercised once in whole or in part at any time notmore than 30 days subsequent to the date of this Agreement upon notice in writing or by facsimile by the Representative to the Company settingforth the amount (which shall be an integral multiple of $1,000) of Optional Notes as to which the Initial Purchasers are exercising the Option andwhich Initial Purchaser or Initial Purchasers, severally and not jointly, are exercising such option. The date for the delivery of and payment for any Optional Notes, being herein referred to as an "Optional Delivery Date," which may be the First Delivery Date (the First Delivery Date and the Optional Delivery Date, if any, being sometimes referred to as a "Delivery Date"), shall bedetermined by the Initial Purchasers but shall not be later than five full business days after written notice of election to purchase Optional Notes isgiven. Delivery of the Optional Notes shall be made to the Initial Purchasers against payment of the purchase price by the Initial Purchasers.Payment for the Optional Notes shall be effected either by wire transfer of immediately available funds to an account with a bank in The City ofNew York, the account number and the ABA number for such bank to be provided by the Company to the Initial Purchasers at least twobusiness days in advance of the Optional Delivery Date, or by such other manner of payment as may be agreed by the Company and the InitialPurchasers. (c) The Company will deliver against payment of the purchase price the Notes in the form of one or more permanent global certificates (the"Global Notes"), registered in the name of Cede & Co., as nominee for The Depository Trust Company ("DTC"). Beneficial interests in the Noteswill be shown on, and transfers thereof will be effected only through, records maintained in book-entry form by DTC and its participants. The Global Notes will be made available, at the request of the Initial Purchasers, for checking at least 24 hours prior to such Delivery Date. (d) Time shall be of the essence, and delivery at the time and place specified pursuant to this Agreement is a further condition of theobligations of the Initial Purchasers hereunder. 3. Further Agreements of the Company. The Company further agrees: (a) To advise the Initial Purchasers promptly of any proposal to amend or supplement the Offering Memorandum and not to effect any suchamendment or supplement without the consent of the Initial Purchasers, which shall not be unreasonably withheld. If, at any time prior tocompletion of the resale of the Notes by the Initial Purchasers, any event shall occur or condition exist as a result of which it is necessary toamend or supplement the Offering Memorandum in order that the Offering Memorandum will not include an untrue statement of a material fact oromit to state any material fact necessary in order to make the statements therein, in the light of the circumstances under which they were made,not misleading, to promptly notify the Initial Purchasers and prepare, subject to the first sentence of this Section 3(a), such amendment orsupplement as may be necessary to correct such untrue statement or omission. (b) To furnish to the Initial Purchasers and to Cleary, Gottlieb, Steen & Hamilton, counsel to the Initial Purchasers, copies of the PreliminaryOffering Memorandum and the Offering Memorandum (and all amendments and supplements thereto), in each case as soon as available and insuch quantities as the Initial Purchasers reasonably requests for internal use and for distribution to prospective purchasers. The Company will paythe expenses of printing and distributing to the Initial Purchasers all such documents. (c) To promptly take such action as the Initial Purchasers may reasonably request from time to time, to qualify the Notes for offering andsale under the securities laws of such jurisdictions as the Initial Purchasers may request and to comply with such laws so as to permit thecontinuance of sales and dealings therein in such jurisdictions in the United States for as long as may be necessary to complete the resale of theNotes; provided, however, that in connection therewith, the Company shall not be required to qualify to do business as a foreign corporation orotherwise subject itself to service of process or taxation in any jurisdiction in which it is not otherwise so qualified or subject. (d) To apply the net proceeds from the sale of the Notes as set forth under "Use of Proceeds" in the Offering Memorandum. (e) Except for the offering of 1,200,000 shares of Common Stock and any additional shares of Common Stock issued pursuant to anunderwriter's option granted to the underwriters thereof, and except for the issuance of options pursuant to the Company's Stock Option Plans inthe ordinary course of business and the issuance of shares of Common Stock upon the exercise of outstanding options and warrants, for a periodof 90 days from the date of the Offering Memorandum, not to, directly or indirectly, offer for sale, sell or otherwise dispose of (or enter into anytransaction or device which is designed to, or could be expected to, result in the disposition by any person at any time in the future of), orannounce an offering of any shares of Common Stock (other than the Conversion Shares), or sell or grant options, rights or warrants with respectto any shares of Common Stock without the prior written consent of the Representatives. In addition, if the Company files a registration statement(other than a Registration Statement) for the resale of shares of its Common Stock during the 90 days from the date of the Offering Memorandum,the Company agrees that it will not request that the Commission declare such registration statement effective during that period unless theCompany is contractually obligated to do so. (f) During the period of two years after the Delivery Date, not to, and not to permit any of its affiliates to, resell any Notes or ConversionShares that have been acquired by any of them. (g) Not to, and not to permit any of its affiliates or any person acting on its behalf to, directly or indirectly, make offers or sales of anysecurity, or solicit offers to buy any security, under circumstances that would require the registration of the Notes or Conversion Shares under theAct. (h) Not to, and not to permit any of its affiliates or any person acting on its behalf (other than the Initial Purchasers) to, engage in any form ofgeneral solicitation or general advertising (within the meaning of Regulation D) in connection with any offer or sale of the Notes in the UnitedStates. (i) To cause each of the Notes to bear, to the extent applicable, the legend contained in "Notice to Investors" in the Offering Memorandum forthe time period and upon the other terms stated therein, except after the Notes are resold pursuant to a registration statement effective under theAct. (j) Between the date hereof and the Delivery Date, not to do or authorize any act or thing that would result in an adjustment of the ConversionPrice (as defined in the Indenture). (k) For a period of two years from the Delivery Date, to take such steps as shall be necessary to ensure that neither the Company nor anysubsidiary shall become an "investment company" within the meaning of such term under the Investment Company Act of 1940, as amended, andthe rules and regulations of the Commission thereunder. (l) Not to take, and not to permit any of its affiliates to take, directly or indirectly, any action which is designed to stabilize or manipulate, orwhich constitutes or which might reasonably be expected to cause or result in stabilization or manipulation, of the price of any security of theCompany in connection with the offering of the Notes. (m) To execute and deliver the Registration Rights Agreement (in form and substance satisfactory to the Initial Purchasers). (n) To use its best efforts to assist the Initial Purchasers in arranging to cause the Notes to be accepted to trade in the PORTAL market("PORTAL") of the National Association of Securities Dealers, Inc. ("NASD"). (o) To use its best efforts to cause the Notes to be accepted for clearance and settlement through the facilities of DTC. (p) To use its best efforts to have the Conversion Shares approved by the NASDAQ National Market for inclusion prior to the effectiveness ofthe Registration Statement. 4. Expenses. Whether or not the transactions contemplated by this Agreement are consummated or this Agreement becomes effectiveor is terminated, the Company agrees to pay: (a) the costs incident to the preparation, printing and distribution of the Preliminary Offering Memorandum, the Offering Memorandum and anyamendment or supplement to the Offering Memorandum, all as provided in this Agreement; (b) the costs of producing and distributing the Operative Documents; (c) the fees and expenses of Bracewell & Patterson, L.L.P. and PricewaterhouseCoopers LLP; (d) the fees and expenses of qualifying the Notes under the securities laws of the several jurisdictions as provided in Section 3(c) and ofpreparing, printing and distributing a blue sky memorandum (including reasonable related fees and expenses of counsel to the Initial Purchasers,not to exceed $5,000); (e) all costs and expenses relating to investor presentations on any "road show" undertaken in connection with the marketing of the offeringof the Notes, including, without limitation, expenses associated with the production of road show slides and graphics, fees and expenses of anyconsultants engaged in connection with the road show presentations with the prior approval of the Company, travel and lodging expenses of therepresentatives and officers of the Company and any such consultants, and the cost of any aircraft chartered in connection with the road show; (f) all fees and expenses incurred in connection with any rating of the Notes; (g) the costs of preparing the Notes; (h) all expenses and fees in connection with the application for inclusion of the Notes in the PORTAL market and the inclusion of theConversion Shares on the Nasdaq National Market; (i) the fees and expenses (including fees and disbursements of counsel) of the Trustee, and the costs and charges of any registrar, transferagent, paying agent or conversion agent; and (j) all other costs and expenses incident to the Company's performance of its obligations under this Agreement;provided that, except as provided in this Section 4 and in Section 7, the Initial Purchasers shall pay their own costs and expenses,including the costs and expenses of their counsel and any transfer taxes on the Notes which they may sell, and the expenses ofadvertising any offering of the Securities made by the Initial Purchasers. 5. Conditions of the Initial Purchaser's Obligations. The respective obligations of the Initial Purchasers hereunder are subject to theaccuracy, when made and on each Delivery Date, of the representations and warranties of the Company contained herein, to the performance bythe Company of its obligations hereunder, and to each of the following additional terms and conditions: (a) The Initial Purchasers shall not have discovered and disclosed to the Company prior to or on such Delivery Date that the OfferingMemorandum or any amendment or supplement thereto contains any untrue statement of a fact which, in the opinion of counsel to the InitialPurchasers, is material or omits to state any fact which is material and necessary to make the statements therein, in the light of thecircumstances under which they were made, not misleading. (b) All corporate proceedings and other legal matters incident to the authorization, form and validity of the Operative Documents and theOffering Memorandum or any amendment or supplement thereto, and all other legal matters relating to the Operative Documents and thetransactions contemplated thereby shall be reasonably satisfactory in all material respects to counsel to the Initial Purchasers, and the Companyshall have furnished to such counsel all documents and information that they may reasonably request to enable them to pass upon such matters. (c) Bracewell & Patterson, L.L.P. shall have furnished to the Initial Purchasers their written opinion, as counsel to the Company, addressedto the Initial Purchasers and dated such Delivery Date, in substantially the form attached hereto as Exhibit A. (d) The Initial Purchasers shall have received from Cleary, Gottlieb, Steen & Hamilton, counsel for the Initial Purchasers, such opinion oropinions, addressed to the Initial Purchasers, dated such Delivery Date, with respect to the issuance and sale of the Notes, the OfferingMemorandum and other related matters as the Initial Purchasers may reasonably require, and the Company shall have furnished to such counselsuch documents as they reasonably request for the purpose of enabling them to pass upon such matters. (e) At the time of execution of this Agreement, the Initial Purchasers shall have received from PricewaterhouseCoopers LLP a letter, in formand substance satisfactory to the Initial Purchasers, addressed to the Initial Purchasers and dated the date hereof (i) confirming that they are anindependent registered public accounting firm within the meaning of the Act and are in compliance with the applicable requirements relating to thequalification of accountants under Rule 2-01 of Regulation S-X of the Commission, and (ii) stating, as of the date hereof (or, with respect tomatters involving changes or developments since the respective dates as of which specified financial information is given in the OfferingMemorandum, as of a date not more than five days prior to the date hereof), the conclusions and findings of such firm with respect to the financialinformation and other matters ordinarily covered by accountants' "comfort letters" to underwriters in connection with registered public offerings. (f) With respect to the letter of PricewaterhouseCoopers LLP referred to in the preceding paragraph and delivered to the Initial Purchasersconcurrently with the execution of this Agreement (the "initial letters"), the Company shall have furnished to the Initial Purchasers a letter (the"bring-down letter") of such accountants, addressed to the Initial Purchasers and dated such Delivery Date (i) confirming that they are an independent registered public accounting firm within the meaning of the Act and are in compliance with the applicable requirements relating to thequalification of accountants under Rule 2-01 of Regulation S-X of the Commission, (ii) stating, as of the date of the bring-down letter (or, withrespect to matters involving changes or developments since the respective dates as of which specified financial information is given in theOffering Memorandum, as of a date not more than five days prior to the date of the bring-down letter), the conclusions and findings of such firmwith respect to the financial information and other matters covered by the initial letter and (iii) confirming in all material respects the conclusionsand findings set forth in the initial letter. (g) The Company shall have furnished to the Initial Purchasers on such Delivery Date a certificate, dated such Delivery Date and deliveredon behalf of the Company by its chief executive officer or its chief financial officer, in form and substance satisfactory to the Initial Purchasers, tothe effect that:(i)The representations, warranties and agreements of the Company in Section 1 are true and correct as of such Delivery Date;and the Company has complied with all its agreements contained herein;(ii)Neither the Company nor any of its subsidiaries shall have sustained since the date of the latest audited financial statementsincluded in the Offering Memorandum (A) any loss or interference with its business from fire, explosion, flood or othercalamity, whether or not covered by insurance, or from any labor dispute or court or governmental action, order or decree,otherwise than as set forth or contemplated in the Offering Memorandum (exclusive of any amendment or supplementthereto), and (B) since such date there has not been any material change in the capital stock or long-term debt of theCompany (other than the issuance of shares of the Common Stock as contemplated by the Offering Memorandum) or any ofits subsidiaries, or any change, or any development involving a prospective change, in or affecting the general affairs,management, financial position, stockholders' equity or results of operations of the Company and its subsidiaries, otherwisethan as set forth or contemplated in the Offering Memorandum (exclusive of any amendment or supplement thereto); and (iii)Such officer has carefully examined the Offering Memorandum and, in such officer's opinion (A) the Offering Memorandum, asof its date, did not include any untrue statement of a material fact and did not omit to state any material fact required to bestated therein or necessary to make the statements therein, in light of the circumstances under which they were made, notmisleading, and (B) since the date of the Offering Memorandum, no event has occurred which should have been set forth in asupplement or amendment to the Offering Memorandum. (h) The Indenture shall have been duly executed and delivered by the Company and the Trustee and the Notes shall have been dulyexecuted and delivered by the Company and duly authenticated by the Trustee. (i) The Company and the Initial Purchasers shall have executed and delivered the Registration Rights Agreement (in form and substancesatisfactory to the Initial Purchasers) and the Registration Rights Agreement shall be in full force and effect. (j) The NASD shall have accepted the Notes for trading on PORTAL. (k) (i) Neither the Company nor any of its subsidiaries shall have sustained since the date of the latest audited financial statements includedin the Offering Memorandum any loss or interference with its business from fire, explosion, flood or other calamity, whether or not covered byinsurance, or from any labor dispute or court or governmental action, order or decree, except as set forth or contemplated in the OfferingMemorandum (exclusive of any amendment or supplement thereto) and (ii) since such date there shall not have been any material change in thecapital stock or long-term debt of the Company (other than the issuance of shares of the Common Stock as contemplated by the OfferingMemorandum) or any of its subsidiaries, or any change, or any development involving a prospective change, in or affecting the general affairs,management, financial position, stockholders' equity or results of operations of the Company and its subsidiaries, otherwise than as set forth orcontemplated in the Offering Memorandum (exclusive of any amendment or supplement thereto), the effect of which, in any such case describedin clause (i) or (ii), is, in the judgment of the Initial Purchasers, so material and adverse as to make it impracticable or inadvisable to proceed withthe sale or the delivery of the Notes being delivered on such Delivery Date on the terms and in the manner contemplated in the OfferingMemorandum (exclusive of any amendment or supplement thereto). (l) Subsequent to the execution and delivery of this Agreement there shall not have occurred any of the following:(i)trading in securities generally on the New York Stock Exchange, Inc. ("NYSE"), the American Stock Exchange, the NasdaqNational Market or the over-the-counter market, or trading in any securities of the Company on any exchange (including theNasdaqNational Market) shall have been suspended or the settlement of such trading generally shall have been materially disrupted,or minimum prices shall have been established on any such exchange or market by the Commission, by such exchange or byany other regulatory body or governmental authority having jurisdiction;(ii)a banking moratorium shall have been declared by United States federal or New York State authorities; (iii)the United States shall have become engaged in hostilities, other than in Iraq and Afghanistan, there shall have been anescalation in hostilities involving the United States, or there shall have been a declaration of a national emergency or war bythe United States; or (iv)there shall have occurred such a material adverse change in general economic, political or financial conditions, includingwithout limitation as a result of terrorist activities after the date hereof, or the effect of international conditions on the financialmarkets in the United States shall be such as to make it, in the sole judgment of the Initial Purchasers, impracticable orinadvisable to proceed with the offering or delivery of the Notes being delivered on such Delivery Date on the terms and in themanner contemplated in the Offering Memorandum (exclusive of any amendment or supplement thereto). (m) The Company shall have furnished to the Initial Purchasers such further information, certificates and documents as the Initial Purchasersmay reasonably request to evidence compliance with the conditions set forth in this Section 5. (n) The members of the board of directors of the Company and the executive officers of the Company shall have furnished to the InitialPurchasers "lock-up" letters, covering a period of 60 days from the date of the Offering Memorandum, in form and substance satisfactory to theInitial Purchasers. (o) All opinions, letters, evidence and certificates mentioned above or elsewhere in this Agreement shall be deemed to be in compliance withthe provisions hereof only if they are in form and substance reasonably satisfactory to counsel to the Initial Purchasers. 6. Representations, Warranties and Agreements of Initial Purchasers. Each Initial Purchaser represents and warrants, severally and notjointly, that it is a Qualified Institutional Buyer. Each such Initial Purchaser, severally and not jointly, represents, warrants and agrees with theCompany that: (a) The Notes and the Conversion Shares have not been and will not be registered under the Act in connection with the initial offering of theNotes; (b) The Initial Purchaser is purchasing the Notes pursuant to a private sale exemption from registration under the Act; (c) The Notes have not been and will not be offered or sold by the Initial Purchaser or its affiliates acting on its behalf within the UnitedStates or to, or for the account or benefit of, United States persons except in accordance with Rule 144A; and (d) The Initial Purchaser will not offer or sell the Notes in the United States by means of any form of general solicitation or general advertising(as those terms are used in Regulation D). 7. Indemnification and Contribution. (a) The Company shall indemnify and hold harmless each of the Initial Purchasers, and their respective directors, officers and employeesand each person, if any, who controls such Initial Purchaser within the meaning of the Act, from and against any loss, claim, damage or liability,joint or several, or any action in respect thereof (including, but not limited to, any loss, claim, damage, liability or action relating to purchases andsales of the Notes), to which such Initial Purchaser, director, officer, employee or controlling person may become subject, under the Act orotherwise, insofar as such loss, claim, damage, liability or action arises out of, or is based upon:(i)any untrue statement or alleged untrue statement of a material fact contained in (A) any Preliminary Offering Memorandum orthe Offering Memorandum, or in any amendment or supplement thereto, or (B) any materials or information provided toinvestors by, or with the approval of, the Company in connection with the marketing of the offering of the Notes, including anyroadshow or investor presentations made to investors by the Company (whether in person or electronically), ("MarketingMaterials") or (ii)the omission or alleged omission to state therein any material fact required to be stated therein or necessary to make thestatements therein, in light of the circumstances under which they were made, not misleading, or (iii)any act or failure to act or any alleged act or failure to act by the Initial Purchasers in connection with, or relating in anymanner to, the Notes or the offering contemplated hereby, and which is included as part of or referred to in any loss, claim,damage, liability or action arising out of or based upon matters covered by clause (i) or (ii) above (provided that the Companyshall not be liable under this clause (iii) to the extent that it is determined in a final judgment by a court of competentjurisdiction that such loss, claim, damage, liability or action resulted directly from any such acts or failure to act undertaken oromitted to be taken by the Initial Purchasers through its gross negligence or willful misconduct),and shall reimburse such Initial Purchaser and each such director, officer, employee and controlling person promptly upon demand for any legal orother expenses reasonably incurred by such Initial Purchaser, director, officer, employee or controlling person in connection with investigating ordefending or preparing to defend against any such loss, claim, damage, liability or action as such expenses are incurred; provided, however, thatthe Company shall not be liable in any such case to the extent that any such loss, claim, damage, liability or action arises out of, or is basedupon, any untrue statement or alleged untrue statement or omission or alleged omission made in any Preliminary Offering Memorandum or theOffering Memorandum, or in any such amendment or supplement, or in any Marketing Materials in reliance upon and in conformity with the writteninformation furnished to the Company by or on behalf of the Initial Purchasers specifically for inclusion therein which information consists solely ofthe information specified in Section 7(e) of this Agreement. The foregoing indemnity agreement is in addition to any liability that the Company mayotherwise have to any Initial Purchaser or to any officer, employee or controlling person of that Initial Purchaser provided further, that the Companyshall not be liable to any Initial Purchaser (or any of their directors, officers, employees or controlling persons) under the indemnity agreement inthis Section 7(a) to the extent, but only to the extent, that (1) such loss, claim, damage or liability of such Initial Purchaser (or such director,officer, employee or controlling person) results from an untrue statement of a material fact or an omission of a material fact contained in thePreliminary Offering Memorandum, which untrue statement or omission was completely corrected in the Offering Memorandum and (2) theCompany sustains the burden of proving that such Initial Purchaser sold the Notes to the person alleging such loss, claim, liability, expense ordamage without sending or giving, at or prior to written confirmation of such sale, a copy of the Offering Memorandum and (3) the Company hadpreviously furnished sufficient quantities of the Offering Memorandum to the Initial Purchasers within a reasonable amount of time prior to suchsale, and (4) such Initial Purchaser failed to deliver the Offering Memorandum, if required by law to have so delivered it, and such delivery wouldhave been a complete defense against the person asserting such loss, claim, liability, expense or damage. The foregoing indemnity agreement isin addition to any liability that the Company may otherwise have to any Initial Purchaser or to any director, officer, employee or controlling personof that Initial Purchaser. (b) Each Initial Purchasers shall, severally and not jointly, indemnify and hold harmless the Company, its officers and employees, each of itsdirectors, and each person, if any, who controls the Company within the meaning of the Act from and against any loss, claim, damage or liability,joint or several, or any action in respect thereof, to which the Company or any such director, officer or controlling person may become subject,under the Securities Act or otherwise, insofar as such loss, claim, damage, liability or action arises out of, or is based upon:(i)any untrue statement or alleged untrue statement of a material fact contained in any Preliminary Offering Memorandum or theOffering Memorandum or in any amendment or supplement thereto, or in any Marketing Materials, or (ii)the omission or alleged omission to state therein any material fact necessary to make the statements therein not misleading,but in each case only to the extent that the untrue statement or alleged untrue statement or omission or alleged omission was made in relianceupon and in conformity with the written information furnished to the Company by or on behalf of the Initial Purchasers specifically for inclusiontherein and described in Section 7(e). The Initial Purchasers shall reimburse the Company and any such director, officer or controlling person forany legal or other expenses reasonably incurred by the Company or any such director, officer or controlling person in connection with investigatingor defending or preparing to defend against any such loss, claim, damage, liability or action as such expenses are incurred. The foregoingindemnity agreement is in addition to any liability which any Initial Purchaser may otherwise have to the Company or any such director, officer orcontrolling person. (c) Promptly after receipt by an indemnified party under this Section 7 of notice of any claim or the commencement of any action, theindemnified party shall, if a claim in respect thereof is to be made against the indemnifying party under this Section 7, notify the indemnifying partyin writing of the claim or the commencement of that action; provided, however, that the failure to notify the indemnifying party shall not relieve itfrom any liability which it may have under this Section 7 except to the extent it has been materially prejudiced by such failure and, provided,further, that the failure to notify the indemnifying party shall not relieve it from any liability which it may have to an indemnified party otherwise thanunder this Section 7. If any such claim or action shall be brought against an indemnified party, and it shall notify the indemnifying party thereof, theindemnifying party shall be entitled to participate therein and, to the extent that it wishes, jointly with any other similarly notified indemnifying party,to assume the defense thereof with counsel reasonably satisfactory to the indemnified party. After notice from the indemnifying party to theindemnified party of its election to assume the defense of such claim or action, the indemnifying party shall not be liable to the indemnified partyunder this Section 7 for any legal or other expenses subsequently incurred by the indemnified party in connection with the defense thereof otherthan reasonable costs of investigation; provided, however, that the Initial Purchasers shall have the right to employ counsel to represent jointly theInitial Purchasers and their respective officers, employees and controlling persons who may be subject to liability arising out of any claim inrespect of which indemnity may be sought by the Initial Purchasers against the Company under this Section 7 if, in the reasonable judgment of theInitial Purchasers, it is advisable for the Initial Purchasers and those directors, officers, employees and controlling persons to be jointlyrepresented by separate counsel, and in that event the fees and expenses of such separate counsel shall be paid by the Company. Noindemnifying party shall:(i)without the prior written consent of the indemnified parties (which consent shall not be unreasonably withheld or delayed)settle or compromise or consent to the entry of any judgment with respect to any pending or threatened claim, action, suit orproceeding in respect of which indemnification or contribution may be sought hereunder (whether or not the indemnified partiesare actual or potential parties to such claim or action) unless such settlement, compromise or consent includes anunconditional release of each indemnified party from all liability arising out of such claim, action, suit or proceeding, or (ii)be liable for any settlement of any such action effected without its written consent (which consent shall not be unreasonablywithheld or delayed), but if settled with such consent of the indemnifying party or if there be a final judgment for the plaintiff inany such action, the indemnifying party agrees to indemnify and hold harmless any indemnified party from and against anyloss or liability by reason of such settlement or judgment. (d) If the indemnification provided for in this Section 7 shall for any reason be unavailable or insufficient to hold harmless an indemnified partyunder Section 7(a) or 7(b) in respect of any loss, claim, damage or liability, or any action in respect thereof, referred to therein, then eachindemnifying party shall, in lieu of indemnifying such indemnified party, contribute to the amount paid or payable by such indemnified party as aresult of such loss, claim, damage or liability, or action in respect thereof:(i)in such proportion as shall be appropriate to reflect the relative benefits received by the Company on the one hand and theInitial Purchasers on the other from the offering of the Notes, or (ii)if the allocation provided by clause 7(d)(i) is not permitted by applicable law, in such proportion as is appropriate to reflect notonly the relative benefits referred to in clause 7(d)(i) but also the relative fault of the Company on the one hand and the InitialPurchasers on the other with respect to the statements or omissions or alleged statements or alleged omissions that resultedin such loss, claim, damage or liability (or action in respect thereof), as well as any other relevant equitable considerations.The relative benefits received by the Company on the one hand and the Initial Purchasers on the other with respect to such offering shall bedeemed to be in the same proportion as the total net proceeds from the offering of the Notes purchased under this Agreement (before deductingexpenses) received by the Company on the one hand, and the total discounts and commissions received by the Initial Purchasers with respect tothe Notes purchased under this Agreement, on the other hand, bear to the total gross proceeds from the offering of the Notes under thisAgreement. The relative fault shall be determined by reference to whether any untrue or alleged untrue statement of a material fact or omission oralleged omission to state a material fact relates to information supplied by the Company or the Initial Purchasers, the intent of the parties and theirrelative knowledge, access to information and opportunity to correct or prevent such statement or omission. The Company and the InitialPurchasers agree that it would not be just and equitable if the amount of contributions pursuant to this Section 7(d) were to be determined by prorata allocation (even if the Initial Purchasers were treated as one entity for such purpose) or by any other method of allocation which does not takeinto account the equitable considerations referred to herein. The amount paid or payable by an indemnified party as a result of the loss, claim,damage or liability, or action in respect thereof, referred to above in this Section 7(d) shall be deemed to include, for purposes of this Section 7(d),any legal or other expenses reasonably incurred by such indemnified party in connection with investigating or defending any such action or claim.Notwithstanding the provisions of this Section 7(d), no Initial Purchaser shall be required to contribute any amount in excess of the amount bywhich the total price at which the Notes resold by it in the initial placement of such Notes were offered to investors exceeds the amount of any damages which such Initial Purchaser has otherwise paid or become liable to pay by reason of the untrue or alleged untrue statement or omissionor alleged omission. No person guilty of fraudulent misrepresentation (within the meaning of Section 11(f) of the Act) shall be entitled tocontribution from any person who was not guilty of such fraudulent misrepresentation. The Initial Purchasers obligations to contribute as providedin this Section 7(d) are several in proportion to their respective obligations and not joint. (e) The Initial Purchasers severally confirm and the Company acknowledges that the statements with respect to the offering of the Notes(i) in the last paragraph of the cover page of the Preliminary Offering Memorandum and the Offering Memorandum, (ii) in the 4th paragraph underthe caption "Plan of Distribution" in the Preliminary Offering Memorandum and the Offering Memorandum and (iii) the 1st paragraph under thecaption "Plan of Distribution—Stabilization, Short Positions, Market Making and Trading," are correct and constitute the only information furnished in writing to the Company by the Initial Purchasers specifically for inclusion in the Preliminary Offering Memorandum and the OfferingMemorandum, as the case may be. 8. Defaulting Initial Purchasers. (a) If, on the Delivery Date, any Initial Purchaser defaults in the performance of its obligations under thisAgreement, the remaining non-defaulting Initial Purchasers shall be obligated to purchase the number of Notes which the defaulting InitialPurchaser agreed but failed to purchase on the Delivery Date in the respective proportions which the aggregate amount of Notes set opposite thename of each remaining non-defaulting Initial Purchaser in Schedule 1 hereto bears to the aggregate amount of Notes set forth opposite the namesof all the remaining non-defaulting Initial Purchasers in Schedule 1 hereto; provided, however, that the remaining non-defaulting Initial Purchasersshall not be obligated to purchase any of the Notes on the Delivery Date if the total amount of Notes which the defaulting Initial Purchaser or InitialPurchasers agreed but failed to purchase on such date exceeds 10% of the total aggregate amount of the Notes to be purchased on the DeliveryDate. If the foregoing maximum is exceeded, the remaining non-defaulting Initial Purchasers, or those other purchasers satisfactory to theRepresentative who so agree, shall have the right, but shall not be obligated, to purchase, in such proportion as may be agreed upon among them,the total amount of Notes to be purchased on the Delivery Date. If the remaining Initial Purchasers or other underwriters satisfactory to theRepresentative do not elect to purchase on the Delivery Date the aggregate amount of Notes which the defaulting Initial Purchasers agreed butfailed to purchase, this Agreement shall terminate without liability on the part of any non-defaulting Initial Purchaser and the Company, except thatthe Company will continue to be liable for the payment of expenses to the extent set forth in Sections 4, 7 and 10. As used in this Agreement, theterm "Initial Purchaser" includes, for all purposes of this Agreement unless the context requires otherwise, any party not listed in Schedule 1hereto who, pursuant to this Section 8(a), purchases Notes which a defaulting Initial Purchaser agreed but failed to purchase. (b) Nothing contained herein shall relieve a defaulting Initial Purchaser of any liability it may have to the Company for damages caused by itsdefault. If other Initial Purchasers are obligated or agree to purchase the Notes of a defaulting or withdrawing Initial Purchaser, either theRepresentative or the Company may postpone the Delivery Date for up to seven full Business Days in order to effect any changes that, in theopinion of counsel to the Company or counsel to the Initial Purchasers, may be necessary in the Offering Memorandum or in any other documentor arrangement. 9. Termination. The obligations of the Initial Purchasers hereunder may be terminated by the Initial Purchasers by notice given to andreceived by the Company prior to delivery of and payment for the Notes if, prior to that time, any of the events described in Sections 5(k) or(l) shall have occurred or if the Initial Purchasers shall decline to purchase the Notes for any reason permitted under this Agreement. 10. Reimbursement of Initial Purchasers' Expenses. If (a) the Company shall fail to tender the Notes for delivery to the Initial Purchasersby reason of any failure, refusal or inability on the part of the Company to perform any agreement on its part to be performed, or because any othercondition of the Initial Purchasers' obligations hereunder required to be fulfilled by the Company (including, without limitation, with respect to thetransactions) is not fulfilled or (b) the Initial Purchasers shall decline to purchase the Notes for any reason permitted under this Agreement(including the termination of this Agreement pursuant to Section 9), the Company shall reimburse the Initial Purchasers for the fees and expensesof their counsel and for such other out-of-pocket expenses as shall have been incurred by them in connection with this Agreement and theproposed purchase of the Notes, and upon demand the Company shall pay the full amount thereof to the Initial Purchasers. If this Agreement isterminated pursuant to Section 8 by reason of the default of one or more Initial Purchasers, the Company shall not be obligated to reimburse anydefaulting Initial Purchasers on account of those expenses, but shall continue to be obligated to reimburse the other Initial Purchasers. 11. Notices, etc. All statements, requests, notices and agreements hereunder shall be in writing, and: (a) if to the Initial Purchasers, shall be delivered or sent by mail, telex or facsimile transmission to Lehman Brothers Inc., 745 SeventhAvenue, New York, New York 10019, Attention: Syndicate Department (Fax: 1-212-526-0943); and (b) if to the Company, shall be delivered or sent by mail, telex or facsimile transmission to Overstock.com, Inc., 6322 South 3000 East,Suite 100, Salt Lake City, UT 84121, Attention: Jonathan E. Johnson III (Fax: 1-801-947-3144), with a copy to (which shall not constitute notice)Bracewell & Patterson, L.L.P., 111 Congress Avenue, Suite 2300, Austin, Texas 78701, Attention Thomas W. Adkins (Fax: 1-512-479-3940).Any such statements, requests, notices or agreements shall take effect at the time of receipt thereof. 12. Persons Entitled to Benefit of Agreement. This Agreement shall inure to the benefit of and be binding upon the Initial Purchasers, theCompany and their respective successors. This Agreement and the terms and provisions hereof are for the sole benefit of only those persons,except that the representations, warranties, indemnities and agreements of the Company contained in this Agreement shall also be deemed to befor the benefit of the directors, officers and employees of the Initial Purchasers and the person or persons, if any, who control any Initial Purchaserwithin the meaning of Section 15 of the Act and any indemnity agreement of the Initial Purchasers contained in Section 7(b) of this Agreementshall be deemed to be for the benefit of directors, officers and employees of the Company, and any person controlling the Company within themeaning of Section 15 of the Act. Nothing contained in this Agreement is intended or shall be construed to give any person, other than the personsreferred to in this Section 11, any legal or equitable right, remedy or claim under or in respect of this Agreement or any provision contained herein. 13. Survival. The respective indemnities, representations, warranties and agreements of the Company and the Initial Purchaserscontained in this Agreement or made by or on behalf of them, respectively, pursuant to this Agreement, shall survive the delivery of and paymentfor the Notes and shall remain in full force and effect, regardless of any termination or cancellation of this Agreement or any investigation made byor on behalf of any of them or any person controlling any of them. 14. Definition of the Terms "Business Day" and "Subsidiary". For purposes of this Agreement, (a) "business day" means any day onwhich The Nasdaq National Market System is open for trading and (b) "subsidiary" has the meaning set forth in Rule 405 of the rules andregulations promulgated under the Act. 15. Governing Law. This Agreement shall be governed by, and construed in accordance with, the laws of the State of New York. 16. Counterparts. This Agreement may be executed in one or more counterparts and, if executed in more than one counterpart, theexecuted counterparts shall each be deemed to be an original but all such counterparts shall together constitute one and the same instrument. 17. Headings. The headings herein are inserted for convenience of reference only and are not intended to be part of, or to affect themeaning or interpretation of, this Agreement. If the foregoing correctly sets forth the agreement between the Company and the Initial Purchasers, please indicate your acceptance in the space provided for that purpose below. Very truly yours, OVERSTOCK.COM, INC. By Name: Title: Accepted and agreed by:For themselves and as Representativesof the several Initial Purchasers namedin Schedule 1 heretoLEHMAN BROTHERS INC.By Authorized Representative Schedule 1Initial Purchaser Amount of Notesto be PurchasedLehman Brothers Inc. $70,000,000Piper Jaffray & Co 10,00,000Legg Mason Wood Walker, Incorporated 10,00,000WR Hambrect + CO, LLC 10,00,000 Total $100,000,000 EXHIBIT AQuickLinksPURCHASE AGREEMENT QuickLinks -- Click here to rapidly navigate through this documentExhibit 10.38 Summary of Compensation ArrangementsApplicable to Named Executive Officers of Overstock.com, Inc. The Compensation Committee (the "Committee") of the Board of Directors of Overstock.com, Inc. (the "Company") oversees and reviews theCompany's executive compensation policies and programs and approves the form and amount of compensation to be paid to the Company'sexecutive officers.Annual Compensation—Base salaries and bonuses The Company is not a party to any written employment agreement with any of its named executive officers. Effective January 1, 2005, the Company pays each of its named executive officers (as defined in Item 402(a)(3) of Regulation S-K), otherthan its President and chief executive officer, base salaries at the annual rate of $100,000. The Company does not pay its President and chiefexecutive officer, Patrick M. Byrne, any base salary. On February 4, 2005, the Committee approved bonus payments to the named executive officers as a result of the officers' performance in2004 as follows:Name and Title BonusDavid Chidester, Vice President Finance $75,000Jonathan Johnson, Vice President, Corporate Affairs and Legal $75,000Russell (Tad) Martin, Vice President of Merchandising and Operations $75,000Shawn Schwegman, Vice President of Technology $75,000 The Committee had also previously approved additional bonus payments earlier during 2004 to Mr. Johnson in the amount of $50,000 andMr. Chidester in the amount of $20,000. The President and chief executive officer of the Company, Dr. Patrick M. Byrne, is a named executive officer, but declined to accept anybonus payment during or relating to 2004.Long Term Incentive Awards—Stock option awards The Company maintains its 2002 Stock Option Plan, as amended, under which the Committee and the Board have the power to grant optionsand other awards to employees, including the named executive officers. No options or other awards have been made during 2005 to any namedexecutive officer, and no plan or arrangement exists at March 10, 2005 regarding future grants to any named executive officer. During 2004, optiongrants were made to the persons who are now named executive officers of the Company as follows:Name and Title OptionsPatrick M. Byrne, President and chief executive officer 0David Chidester, Vice President Finance 25,000Jonathan Johnson, Vice President, Corporate Affairs and Legal 5,000Russell (Tad) Martin, Vice President of Merchandising and Operations 25,000Shawn Schwegman, Vice President of Technology 10,000 All of the stock options granted have an exercise price per share of $18.58, which was the last sales price of the Company's common stockon the Nasdaq National Market System on the date of grant.QuickLinksSummary of Compensation Arrangements Applicable to Named Executive Officers of Overstock.com, Inc. QuickLinks -- Click here to rapidly navigate through this documentExhibit 10.39 Summary of Compensation ArrangementsApplicable to Non-Employee Directors of Overstock.com, Inc. Overstock.com, Inc. (the "Company") reimburses its non-employee directors for out-of-pocket expenses incurred in connection with attendingBoard and committee meetings. Prior to the third quarter of 2004, the Company did not pay any of its non-employee directors any other cashamounts. Beginning in the third quarter of 2004, the Company began paying its non-employee directors $20,000 annually at the rate of $5,000 perquarter. The Company maintains its 2002 Stock Option Plan, as amended, under which the Board of Directors has the power to grant options andother awards to members of the Board. No options or other awards have been made during 2005 to any non-employee member of the Board.During 2004 the Board granted options to non-employee directors as follows:Name Grant Date Exercise Price ($) Number ofOptions GrantedJohn J. Byrne May 21, 2004 31.13 5,000Gordon Macklin January 23, 2004May 21, 2004 18.5831.13 10,0005,000Allison Abraham January 23, 2004May 21, 2004 18.5831.13 10,0005,000John Fisher January 23, 2004May 21, 2004 18.5831.13 10,0005,000QuickLinksSummary of Compensation Arrangements Applicable to Non-Employee Directors of Overstock.com, Inc. QuickLinks -- Click here to rapidly navigate through this documentExhibit 21 SUBSIDIARIES OF THE REGISTRANT Name Jurisdiction of Formation Trade NamesOverstock Mexico, S. de R.L. de C.V. Mexico Overstock MexicoQuickLinksSUBSIDIARIES OF THE REGISTRANT QuickLinks -- Click here to rapidly navigate through this documentExhibit 23.1 CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM We hereby consent to the incorporation by reference in the Registration Statements on Form S-3 (No. 333-122904), Form S-3 (No. 333-122086), Form S-8 (No. 333-89890) and Form S-8 (No. 333-115806) of Overstock.com, Inc. of our report dated March 14, 2005 relating to thefinancial statements, financial statement schedule, management's assessment of the effectiveness of internal control over financial reporting andthe effectiveness of internal control over financial reporting, which appears in this Form 10-K./s/PricewaterhouseCoopers LLPSalt Lake City, UtahMarch 14, 2005QuickLinksCONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM QuickLinks -- Click here to rapidly navigate through this documentExhibit 31.1 CERTIFICATION I, Patrick M. Byrne, certify that:1.I have reviewed this Annual Report on Form 10-K of Overstock.com, Inc.; 2.Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary tomake the statements made, in light of the circumstances under which such statements were made, not misleading with respect to theperiod covered by this report; 3.Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all materialrespects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4.The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (asdefined in Exchange Act Rules 13a-15(e) and 15(d)-15(e)) and internal control over financial reporting (as defined in Exchange ActRules 13a-15(f) and 15(d)-15(f)) for the registrant and have: (a)designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under oursupervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to usby others within those entities, particularly during the period in which this report is being prepared; (b)designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed underour supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financialstatements for external purposes in accordance with generally accepted accounting principles; (c)evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions aboutthe effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on suchevaluation; and (d)disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's mostrecent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonablylikely to materially affect, the registrant's internal control over financial reporting; and 5.The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financialreporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalentfunctions): (a)all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which arereasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b)any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant'sinternal control over financial reporting.Date: March 15, 2005 /s/ PATRICK M. BYRNE Patrick M. ByrnePresident (principal executive officer)QuickLinksCERTIFICATION QuickLinks -- Click here to rapidly navigate through this documentExhibit 31.2 CERTIFICATION I, David K. Chidester, certify that:1.I have reviewed this Annual Report on Form 10-K of Overstock.com, Inc.; 2.Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary tomake the statements made, in light of the circumstances under which such statements were made, not misleading with respect to theperiod covered by this report; 3.Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all materialrespects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4.The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (asdefined in Exchange Act Rules 13a-15(e) and 15(d)-15(e)) and internal control over financial reporting (as defined in Exchange ActRules 13a-15(f) and 15(d)-15(f)) for the registrant and have: (a)designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under oursupervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to usby others within those entities, particularly during the period in which this report is being prepared; (b)designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed underour supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financialstatements for external purposes in accordance with generally accepted accounting principles; (c)evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions aboutthe effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on suchevaluation; and (d)disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's mostrecent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonablylikely to materially affect, the registrant's internal control over financial reporting; and 5.The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financialreporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalentfunctions): (a)all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which arereasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b)any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant'sinternal control over financial reporting.Date: March 15, 2005 /s/ DAVID K. CHIDESTER David K. ChidesterVice President, Finance (principal financial officer)QuickLinksCERTIFICATION QuickLinks -- Click here to rapidly navigate through this documentEXHIBIT 32.1 CERTIFICATION OF CHIEF EXECUTIVE OFFICERPURSUANT TO18 U.S.C. SECTION 1350,AS ADOPTED PURSUANT TOSECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 I, Patrick M. Byrne, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, thatthe Annual Report of Overstock.com, Inc. on Form 10-K for the year ended December 31, 2004 fully complies with the requirements ofSection 13(a) or 15(d) of the Securities Exchange Act of 1934, as applicable, and that information contained in such Report fairly presents in allmaterial respects the financial condition and results of operations of Overstock.com, Inc. /s/ PATRICK M. BYRNE Name:Patrick M. Byrne Title:President (principal executive officer)QuickLinksCERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906OF THE SARBANES-OXLEY ACT OF 2002 QuickLinks -- Click here to rapidly navigate through this documentEXHIBIT 32.2 CERTIFICATION OF CHIEF FINANCIAL OFFICERPURSUANT TO18 U.S.C. SECTION 1350,AS ADOPTED PURSUANT TOSECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 I, David K. Chidester, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002,that the Annual Report of Overstock.com, Inc. on Form 10-K for the year ended December 31, 2004 fully complies with the requirements ofSection 13(a) or 15(d) of the Securities Exchange Act of 1934, as applicable, and that information contained in such Report fairly presents in allmaterial respects the financial condition and results of operations of Overstock.com, Inc. /s/ DAVID K. CHIDESTER Name:David K. Chidester Title:Vice President, Finance (principal financial officer)QuickLinksCERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OFTHE SARBANES-OXLEY ACT OF 2002
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