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Scientific Learning 10-K 2005
e10vkza
Table of Contents

 
 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K/A

þ Annual Report Pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934

For the fiscal year ended December 31, 2004 or

o Transition Report Pursuant to Section 13 or 15 (d) of the Securities Exchange Act of 1934

For the transition period from                      to                     

COMMISSION FILE NO. 000-24547

SCIENTIFIC LEARNING CORPORATION

(Exact name of registrant as specified in its charter)
     
DELAWARE
(State or other jurisdiction of
incorporation or organization)
  94-3234458
(IRS Employer Identification Number)

300 FRANK H. OGAWA PLAZA, SUITE 600
OAKLAND, CA 94612-2040
(Address of principal executive offices, including zip code)

510-444-3500
(Registrant’s telephone number, including area code)

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

Securities registered pursuant to Section 12 (g) of the Act:
COMMON STOCK,
PAR VALUE
$0.001 PER SHARE

(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 Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes: þ 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 be contained, to the best of the 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: o No: þ

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the Registrant, based upon the closing sale price of the Common Stock on June 30, 2004 as reported on the Nasdaq Small Cap Market was approximately $39,148,211. Shares of Common Stock held by each executive officer and director and by certain persons who owned 5% or more of the Registrant’s outstanding Common Stock on that date have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

 
 

 


Table of Contents

As of March 15, 2005 the Registrant had outstanding 16,669,199 shares of Common Stock.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the Registrant’s 2005 Annual Meeting of Stockholders are incorporated by reference in Part III.

EXPLANATORY NOTE

This Amendment No. 1 on Form 10-K/A amends our Annual Report on Form 10-K for the year ended December 31, 2004, filed on April 15, 2005 (the “Original Form 10-K”) to reflect the restatement of our balance sheet as of December 31, 2004. The restatement of the balance sheet reflects a reclassification of $4,902,000 from deferred revenue, long-term to deferred revenue, current in order to correct a clerical error relating to a contract signed in June 2004 of $4,398,000 and two computational errors totaling $504,000. This restatement is described in more detail in Notes 2 and 16 to the Financial Statements.

We have amended and restated in its entirety each item of the Original Form 10-K that has been changed to reflect the restatement. These items are Part II, Item 6 – Selected Financial Data; Part II, Item 8 — Financial Statements and Supplementary Data; Part II, Item 9A — Controls and Procedures; and certain Exhibits.

Except as stated above, this Report speaks only as of the date of the Original Form 10-K. Except as specified above, this filing does not reflect any events occurring after April 15, 2005.

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PART II

ITEM 6. Selected Financial Data

                 In thousands, except per share amounts

Selected Financial Data

                                         
    Year ended December 31,              
    2004     2003     2002     2001     2000  
                                       
Statement of Operations Data:
                                       
 
                                       
Revenues:
                                       
Products
  $ 22,802     $ 24,491     $ 17,879     $ 11,702     $ 10,983  
Services and support
    8,174       5,425       3,958       3,023       3,079  
 
                             
Total revenues
    30,976       29,916       21,837       14,725       14,062  
 
                                       
Cost of revenues:
                                       
Products
    1,775       2,127       2,109       1,857       1,800  
Services and support
    4,981       3,872       1,502       2,402       1,877  
 
                             
Total cost of revenues
    6,756       5,999       3,611       4,259       3,677  
 
                                       
Gross profit
    24,220       23,917       18,226       10,466       10,385  
 
                                       
Operating expenses:
                                       
Sales and marketing
    16,087       12,961       14,554       19,701       20,981  
Research and development
    3,555       3,500       2,985       3,390       5,680  
General and administrative
    5,313       4,529       4,776       6,348       5,746  
Restructuring, lease and asset impairment write downs
          (7 )     3,365       2,608       492  
 
                             
Total operating expenses
    24,955       20,983       25,680       32,047       32,899  
 
                             
 
                                       
Operating income (loss)
    (735 )     2,934       (7,454 )     (21,581 )     (22,514 )
 
                                       
Interest income (expense), net
    (100 )     (1,209 )     (1,332 )     (1,053 )     1,077  
Other income from related party
    99       448                    
Other income (expense), net
                91       21       2  
 
                             
 
                                       
Net income (loss) before income tax
    (736 )     2,173       (8,695 )     (22,613 )     (21,435 )
Income tax (benefit) provision
    (43 )     43                    
 
                             
 
                                       
Net income (loss)
  $ (693 )   $ 2,130     $ (8,695 )   $ (22,613 )   $ (21,435 )
 
                             
 
                                       
Basic net income (loss) per share
  $ (0.04 )   $ 0.13     $ (0.56 )   $ (1.92 )   $ (1.92 )
 
                             
 
                                       
Shares used in computing basic net income (loss) per share
    16,408       16,007       15,642       11,777       11,148  
 
                             
Diluted net income (loss) per share:
  $ (0.04 )   $ 0.13     $ (0.56 )   $ (1.92 )   $ (1.92 )
 
                             
Shares used in computing diluted net income (loss) per share
    16,408       16,908       15,642       11,777       11,148  
 
                             
 
                                       
Balance Sheet Data:
                                       
 
                                       
Cash and cash equivalents
  $ 10,281     $ 3,648     $ 4,613     $ 4,610     $ 818  
Investments in government securities
                      1,169       7,667  
Working capital restated (1)
    (3,986 )     (11,331 )     (10,879 )     (1,010 )     6,609  
Total assets
    22,958       15,597       18,531       23,228       18,953  
Long-term debt, including current portion
                5,000       10,000        
Stockholders’ (deficit) equity (2)
    (8,111 )     (8,544 )     (11,363 )     (3,247 )     10,281  


(1) The Company has restated its December 31, 2004 balance sheet to reclassify $4,902,000 from long-term deferred revenue into current deferred revenue. This reduced the previously-reported working capital of $916,000 by $4,902,000 to ($3,986,000). For more detail about the restatement of this financial information, see Note 2 to the Financial Statements.
 
(2) We have paid no cash dividends since our inception.

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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Report of Ernst & Young LLP, Independent Registered Public Accounting Firm

The Board of Directors and Stockholders
Scientific Learning Corporation

     We have audited the accompanying balance sheets of Scientific Learning Corporation as of December 31, 2004 and 2003 and the related statements of operations, stockholders deficit, and cash flows for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement schedule listed in the index at Item 15 (a). These financial statements and schedule are the responsibility of Scientific Learning Corporation’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

     We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

     In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Scientific Learning Corporation as of December 31, 2004 and 2003, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

                              /s/ Ernst & Young LLP

Walnut Creek, California
April 11, 2005, except as to Note 2, as to which the date is May 25, 2005.

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Scientific Learning Corporation
Balance Sheet

(In thousands, except share and per share amounts)

                 
    December 31,  
    2004     2003  
    Restated          
Assets
               
Current assets:
               
Cash and cash equivalents
  $ 10,281     $ 3,648  
Accounts receivable, net of allowance for doubtful accounts $121 and $139 at December 31, 2004 and 2003, respectively
    5,661       5,117  
Notes and interest receivable from current and former officers
    3,688        
Prepaid expenses and other current assets
    1,306       1,144  
 
           
 
               
Total current assets
    20,936       9,909  
 
               
Property and equipment, net
    755       537  
Notes and interest receivable from current and former officers
          3,533  
Other assets
    1,267       1,618  
 
           
 
               
Total assets
  $ 22,958     $ 15,597  
 
           
 
               
Liabilities and stockholders’ deficit
               
Current liabilities:
               
Accounts payable
  $ 603     $ 481  
Accrued liabilities
    4,338       3,875  
Deferred revenue
    19,981       16,884  
 
           
 
               
Total current liabilities
    24,922       21,240  
Deferred revenue, long-term
    5,803       2,616  
Other liabilities
    344       285  
 
           
 
               
Total liabilities
    31,069       24,141  
 
               
Commitments and contingencies
               
 
               
Stockholders’ deficit:
               
Preferred stock, $0.001 par value; 1,000,000 shares authorized, no shares issued or outstanding
           
Common stock, $0.001 par value; 40,000,000 shares authorized, 16,657,589 and 16,150,551 shares issued and outstanding at December 31, 2004 and 2003, respectively
    75,586       74,460  
Accumulated deficit
    (83,697 )     (83,004 )
 
           
 
               
Stockholders’ deficit:
    (8,111 )     (8,544 )
 
           
 
               
Total liabilities and stockholders’ deficit
  $ 22,958     $ 15,597  
 
           

See accompanying notes.

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Scientific Learning Corporation
Statement of Operations

(In thousands, except share and per share amounts)

                         
    Year ended December 31,  
    2004     2003     2002  
Revenues:
                       
Products
  $ 22,802     $ 24,491     $ 17,879  
Service and support
    8,174       5,425       3,958  
 
                 
Total revenues
    30,976       29,916       21,837  
 
                       
Cost of revenues:
                       
Cost of products
    1,775       2,127       2,109  
Cost of service and support
    4,981       3,872       1,502  
 
                 
Total cost of revenues
    6,756       5,999       3,611  
 
                       
Gross profit
    24,220       23,917       18,226  
 
                       
Operating expenses:
                       
Sales and marketing
    16,087       12,961       14,554  
Research and development
    3,555       3,500       2,985  
General and administrative
    5,313       4,529       4,776  
Restructuring
          (7 )     3,365  
 
                 
 
                       
Total operating expenses
    24,955       20,983       25,680  
 
                 
 
                       
Operating income (loss)
    (735 )     2,934       (7,454 )
 
                       
Other income from related party
    99       448        
Interest expense, net
    (100 )     (1,209 )     (1,332 )
Other income (expense), net
                91  
 
                 
 
                       
Net income (loss) before income tax
    (736 )     2,173       (8,695 )
 
                       
Income tax (benefit) provision
    (43 )     43        
 
                 
Net income (loss)
  $ (693 )   $ 2,130     $ (8,695 )
 
                 
 
                       
Basic net income (loss) per share:
  $ (0.04 )   $ 0.13     $ (0.56 )
 
                 
Shares used in computing basic net income (loss)
    16,408,039       16,006,565       15,641,849  
 
                 
Diluted net income (loss) per share:
  $ (0.04 )   $ 0.13     $ (0.56 )
 
                 
Shares used in computing diluted net income (loss)
    16,408,039       16,908,361       15,641,849  
 
                 

See accompanying notes.

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Scientific Learning Corporation

Statements of Stockholders’ Deficit
(In thousands, except share amounts)

                                 
                            Total  
    Common Stock       Accumulated     Stockholders’  
    Shares     Amount     Deficit     Deficit  
Balance December 31, 2001
    15,475,619     $ 73,192     $ (76,439 )   $ (3,247 )
Issuance of common stock under stock option plan
    274,471       318             318  
Issuance of common stock under employee stock purchase plan
    116,861       119             119  
Compensation charge relating to granting of common stock options
          122             122  
Stock issued in exchange for services
    12,132       20             20  
Net loss and comprehensive loss
                (8,695 )     (8,695 )
 
                       
Balance December 31, 2002
    15,879,083       73,771       (85,134 )     (11,363 )
Issuance of common stock under stock option plan
    207,438       264             264  
Issuance of common stock under employee stock purchase plan
    52,912       180             180  
Compensation charge relating to granting of common stock options
          198             198  
Stock issued in exchange for services
    11,118       47             47  
Net income and comprehensive income
                2,130       2,130  
 
                       
Balance December 31, 2003
    16,150,551       74,460       (83,004 )     (8,544 )
Issuance of common stock under stock option plan
    417,773       645             645  
Issuance of common stock under employee stock purchase plan
    78,468       300             300  
Compensation charge relating to granting of common stock options
          110             110  
Stock issued in exchange for services
    10,797       71             71  
Net loss and comprehensive loss
                (693 )     (693 )
 
                       
Balance December 31, 2004
    16,657,589     $ 75,586     $ (83,697 )   $ (8,111 )
 
                       

See accompanying notes

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Scientific Learning Corporation
Statement of Cash Flows

(In thousands)

                         
    Year ended December 31,  
    2004     2003     2002  
Operating Activities:
                       
Net (loss) income
  $ (693 )   $ 2,130     $ (8,695 )
Adjustments to reconcile net income (loss) to cash provided by operating activities:
                       
Depreciation
    428       721       1,082  
Amortization of software development costs
    351       617       718  
Amortization of deferred financing costs
    232       1,215       1,216  
Stock based compensation
    181       245       142  
Asset impairment write downs
                50  
Changes in operating assets and liabilities:
                       
Accounts receivable
    (544 )     (250 )     887  
Prepaid expenses and other current assets
    (162 )     428       (52 )
Accounts payable
    122       194       (157 )
Accrued liabilities
    463       (1,339 )     1,814  
Deferred revenue
    6,284       788       6,515  
Other liabilities
    59       (199 )     197  
 
                 
 
                       
Net cash provided by operating activities
    6,721       4,550       3,717  
 
                       
Investing Activities:
                       
Sale of government securities
                1,169  
Purchases of property and equipment, net
    (646 )     (256 )     (124 )
Increase in capitalized software development costs
                (116 )
Increase in other non-current assets
    (387 )     (703 )     (80 )
 
                 
 
                       
Net cash (used in) provided by investing activities
    (1,033 )     (959 )     849  
 
                       
Financing Activities:
                       
Proceeds from issuance of common stock, net
    945       444       437  
Borrowings under bank line of credit
    3,000       2,000       4,000  
Repayments of borrowings under bank line of credit
    (3,000 )     (7,000 )     (9,000 )
 
                 
 
                       
Net cash provided by (used in) financing activities
    945       (4,556 )     (4,563 )
 
                 
 
                       
Increase (decrease) in cash and cash equivalents
    6,633       (965 )     3  
 
                       
Cash and cash equivalents at beginning of year
    3,648       4,613       4,610  
 
                 
 
                       
Cash and cash equivalents at end of year
  $ 10,281     $ 3,648     $ 4,613  
 
                 
 
                       
Supplemental disclosure
                       
Interest paid
  $ 44     $ 134     $ 294  
 
                 

See accompanying notes.

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Notes to Financial Statements
1. Summary of Significant Accounting Policies

Description of Business

Scientific Learning Corporation (the “Company”) provides neuroscience-based software products that develop underlying cognitive skills required for reading and learning. The Company’s Fast ForWord® products are a series of reading intervention products for children, adolescents and adults. We sell primarily to K-12 schools through a direct sales force. The Company also sells to speech and language professionals. To support our products, we provide on-site and remote training and implementation services, as well as technical, professional and customer support and a wide variety of Web-based resources.

The Company was incorporated in 1995 in the State of California and was reincorporated in 1997 in the State of Delaware.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements as well as the reported amounts of revenues and expenses during the periods presented. Actual results may differ from those estimated.

Revenue Recognition

We derive revenue from the sale of licenses to our software and from service and support fees. Software license revenue is recognized in accordance with AICPA Statement of Position 97-2, “Software Revenue Recognition,” as amended by Statement of Position 98-9 (SOP 97-2). SOP 97-2 provides specific industry guidance and four basic criteria, which must be met to recognize revenue. These are: 1) persuasive evidence of an arrangement; 2) delivery of the product; 3) a fixed or determinable fee; and 4) the probability that the fee will be collected.

Sales to our school customers typically include multiple elements (e.g. Fast ForWord software licenses, Progress Tracker, our Internet-based participant tracking service, support, training, implementation management, and other services). The Company allocates revenue to each element of a transaction based upon its fair value as determined in reliance on “vendor specific objective evidence” (“VSOE”). VSOE of fair value for each element of an arrangement is based upon the normal pricing and discounting practices for those products and services when sold separately and, for support services, is also measured by the renewal price.

The value of software licenses, services and support invoiced during a particular period is recorded as deferred revenue until recognized. Deferred revenue is recognized as revenue as discussed below.

License revenue

Revenue from the licensing of software is recognized as follows:

Perpetual licenses – software licensed on a perpetual basis. Revenue is recognized at the later of product delivery date or contract start date using the residual method. If VSOE does not exist for all the undelivered elements, all revenue is deferred and recognized ratably over the service period if the undelivered element is services or when all elements have been delivered.

Term licenses – software licensed for a specific time period, generally three to twelve months. Revenue is recognized ratably over the license term.

Individual participant licenses – software licensed for a single participant. Revenue is recognized over the average period of use, typically six weeks.

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Notes to Financial Statements
1. Summary of Significant Accounting Policies (continued)

Service and support revenue

Service and support revenue is derived from a combination of training, implementation, technical and professional services, online services and customer support. Training, technical and other professional services are typically sold on a per day basis. If VSOE exists for all elements of an arrangement or all elements except software licenses, services revenue is recognized as performed. If VSOE does not exist for all the elements in an arrangement except software licenses, service revenue is recognized over the longest contractual period in an arrangement. Revenue from services sold alone or with support is recognized as performed.

Cash and Cash Equivalents

Cash and cash equivalents consist of cash and highly liquid investments with maturities of three months or less from the time of purchase.

Accounts Receivable

The Company conducts business primarily with public school districts and speech and language professionals in the United States. Ongoing credit evaluations are performed on customers and collateral is generally not required. Allowances for uncollectible accounts are made for potential credit issues based on past experience and management assessment of current risks.

Inventories

Product inventories are stated at the lower of cost or market. Cost is determined using a weighted average approach, which approximates the first-in first-out method. If inventory costs exceed expected market value due to obsolescence or lack of demand, reserves are recorded for the difference between the cost and the market value.

Fair Value of Financial Instruments

The carrying amounts of the Company’s cash and cash equivalents, accounts receivable, notes receivable from current and former officers, and accounts payable approximate fair value.

Concentration of Credit Risk

Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash, cash equivalents and accounts receivable.

Cash and cash equivalents are invested in major financial institutions in the United States. Such deposits may be in excess of insured limits and are not insured in other jurisdictions. Management believes that the financial institutions that hold the Company’s investments are financially sound and, accordingly, minimal credit risk exists with respect to these investments.

The accounts receivable of the Company are derived from sales to customers located primarily in the United States. The Company performs ongoing credit evaluations of its customers. The Company does not require collateral.

An allowance for doubtful accounts is determined with respect to those accounts that the Company has determined to be doubtful of collection. At December 31, 2004 and 2003, no customer accounted for more than 10% of the Company’s accounts receivable.

The company has no off-balance sheet concentration of credit risk, such as foreign exchange contracts, option contracts or other hedging arrangements.

Property and Equipment

Property and equipment are recorded at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, which range from three to five years.

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Table of Contents

Notes to Financial Statements
1. Summary of Significant Accounting Policies (continued)

Software Development Costs

The Company accounts for software development costs in accordance with Statement of Financial Accounting Standards (“FAS”) No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed,” under which certain software development costs incurred subsequent to the establishment of technological feasibility are capitalized and amortized over the estimated lives of the related products. Technological feasibility is established upon completion of a working model. In 2003 and 2004, costs incurred subsequent to the establishment of technological feasibility were not significant, and were charged to research and development expense. The Company capitalized $116,000 of software development costs for the year ended December 31, 2002. Software costs are amortized to cost of product revenues over the estimated useful life of the software, which is three years. Amortization was $351,000, $617,000 and $718,000 for the years ended December 31, 2004, 2003 and 2002, respectively.

Long-Lived Assets

The Company regularly reviews the carrying value of long-lived assets. We continually make estimates regarding future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, the Company may be required to record impairment charges for these assets.

Accounting for Stock-Based Compensation

The Company accounts for stock issued to employees in accordance with Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees” and complies with the disclosure provisions of SFAS No. 123 (“SFAS 123”), “Accounting for Stock-Based Compensation” and SFAS No. 148 (“SFAS 148”), “Accounting for Stock-Based Compensation – Transition and Disclosure.” Under APB 25, compensation expense of fixed stock options is based on the difference, if any, on the date of the grant between the fair value of the Company’s stock and the exercise price of the option. The Company accounts for stock issued to non-employees in accordance with the provisions of SFAS 123 and EITF No. 96-18, “Accounting for Equity Instruments That are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.”

Pro Forma Disclosures of the Effect of Stock-Based Compensation

Pro forma information regarding the results of operations and net income (loss) per share is determined as if the Company had accounted for its employee stock options and employee stock purchase plan stock using the fair value method. The fair value of each option granted and employee stock purchase plan stock issued is estimated on the date of grant using the Black Scholes valuation model with the following assumptions:

                         
    Year ended December 31,  
Employee & Director Stock Options   2004     2003     2002  
Weighted average expected life of option (in years)
    5       5       5  
Risk-free interest rate
    3.0 %     3.0 %     3.0 %
Dividend yield
    0.0 %     0.0 %     0.0 %
Volatility
    85 %     85 %     85 %
Weighted average fair value
  $ 4.00     $ 2.05     $ 0.90  
                         
    Year ended December 31,  
Employee Stock Purchase Plan   2004     2003     2002  
Weighted average expected life (in years)
    0.5 - 1.0       0.5 - 1.0       0.5 - 1.0  
Risk-free interest rate
    3.0 %     3.0 %     3.0 %
Dividend yield
    0.0 %     0.0 %     0.0 %
Volatility
    85 %     85 %     85 %
Weighted average fair value
  $ 2.06     $ 1.56     $ 1.08  

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Table of Contents

Notes to Financial Statements
1. Summary of Significant Accounting Policies (continued)

The Company has elected to use the intrinsic value method in accounting for its employee stock options because, as discussed below, the alternative fair value accounting requires the use of option valuation models that were not developed for use in valuing employee stock options. Under the intrinsic value method, when the exercise price of the Company’s employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized.

The option valuation models were developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected life of the option.

Had compensation cost for the Company’s stock-based compensation plans been determined using the fair value at the grant dates for awards under those plans calculated using the Black Scholes valuation model, the Company’s pro forma net income (loss) and basic and diluted net income (loss) per share would have been as follows (in thousands, except per share amounts):

                           
    Year Ended December 31,
    2004     2003     2002    
Net income (loss), as reported
  $ (693 )   $ 2,130     $ (8,695 )  
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards
    (1,668 )     (1,465 )     (2,472 )  
 
                   
Pro forma net income (loss), per share
  $ (2,361 )   $ 665     $ (11,167 )  
 
                   
Basic, as reported
  $ (0.04 )   $ 0.13     $ (0.56 )  
 
                   
Diluted, as reported
  $ (0.04 )   $ 0.13     $ (0.56 )  
 
                   
Basic, pro forma
  $ (0.14 )   $ 0.04     $ (0.71 )  
 
                   
Diluted, pro forma
  $ (0.14 )   $ 0.04     $ (0.71 )  
 
                   

The pro forma impact of options on the net income (loss) for the years ended December 31, 2004, 2003 and 2002, is not representative of the effects on net income (loss) for future years, as future years will include the effects of additional years of stock option grants.

Advertising

Advertising costs are expensed as incurred. Advertising expense was $13,000, $1,000 and $4,000 for the years ended December 31, 2004, 2003 and 2002, respectively.

Income Taxes

The Company accounts for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes,” which requires the use of the liability method in accounting for income taxes. Under SFAS No. 109, deferred tax assets and liabilities are measured using enacted tax rates and laws that are expected to be in effect when the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the net amount expected to be realized.

Net Income (Loss) per Share

Under the provisions of SFAS No. 128, “Earnings per Share,” basic net income (loss) per share is computed using the weighted-average number of common shares outstanding during the period. Diluted net income (loss) per share reflects the potential dilution of securities by adding common stock equivalents (computed using the treasury stock method) to the weighted-average number of common shares outstanding during the period, if dilutive. Potentially dilutive securities have been excluded from the computation of diluted net loss per share as their inclusion is antidilutive.

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Table of Contents

Notes to Financial Statements
1. Summary of Significant Accounting Policies (continued)

The following table sets forth the computation of net income (loss) per share (in thousands, except share and per share data):

                         
    Year Ended December 31,  
    2004     2003     2002  
Net income (loss)
  $ (693 )   $ 2,130     $ (8,695 )
 
                 
Weighted average shares used in calculation of basic net income (loss) per share
    16,408,039       16,006,565       15,641,849  
Effect of dilutive securities:
                       
Employee stock options
          901,796        
 
                 
Weighted-average diluted common share
    16,408,039       16,908,361       15,641,849  
 
                 
Net income (loss) per common share- basic:
  $ (0.04 )   $ 0.13     $ (0.56 )
 
                 
Net income (loss) per common share- diluted:
  $ (0.04 )   $ 0.13     $ (0.56 )
 
                 

If the Company had reported net income in 2004 or 2002, the calculation of diluted earnings per share would have included the shares used in the computation of basic net loss per share as well as an additional 1,101,352 and 64,000 common equivalent shares (computed using the treasury stock method) related to outstanding stock options not included in the calculations above for the years ended December 31, 2004 and 2002, respectively.

Recent Accounting Pronouncements

SFAS 123(R), “Share-Based Payment”

On December 16, 2004 the FASB issued SFAS 123 (revised 2004), “Share-Based Payment,” which is a revision of SFAS 123, “Accounting for Stock-Based Compensation.” Statement 123(R) supercedes APB 25, “Accounting for Stock Issued to Employees,” and amends SFAS 95, “Statement of Cash Flows.” Generally, the approach in SFAS 123(R) is similar to the approach described in SFAS 123. However, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options and purchases under employee stock purchase plans, to be recognized in the statement of operations based on their fair values. Pro forma disclosure of fair value recognition will no longer be an alternative.

SFAS 123(R) is effective for public companies for annual periods beginning after June 15, 2005, with earlier adoption permitted. We are required to adopt this new standard in our fiscal year beginning January 1, 2006. SFAS 123(R) permits public companies to adopt its requirements using one of two methods:

  1.   A “modified prospective” method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS 123(R) for all share-based payments granted after the effective date and (b) based on the requirements of SFAS 123 for all awards granted to employees prior to the effective date that remain unvested on the effective date.
 
  2.   A “modified retrospective” method which includes the requirements of the modified prospective method described above but also permits restatement using amounts previously disclosed under the pro forma provisions of SFAS 123 either for (a) all prior periods presented or (b) prior interim periods of the year of adoption.

We have not yet chosen a method of adoption for SFAS 123(R).

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Notes to Financial Statements
1. Summary of Significant Accounting Policies (continued)

As permitted by SFAS 123, we currently account for share-based payments to employees using APB 25’s intrinsic value method. As a consequence, we generally recognize no compensation cost for employee stock options and purchases under our Employee Stock Purchase Plan. Although the adoption of SFAS 123(R)’s fair value method will have no adverse impact on our balance sheet or net cash flows, it will have a significant adverse impact on our net income and net income per share. The pro forma effects on net income and earnings per share if we had applied the fair value recognition provisions of SFAS 123 to share-based payments to employees in prior periods are disclosed in Note 1 under “Stock-Based Incentive Programs.” Although the pro forma effects of applying SFAS 123 may be indicative of the effects of applying SFAS 123(R), the provisions of these two statements differ in some important respects. The actual effects of adopting SFAS 123(R) will depend on numerous factors including the valuation model we use to value future share-based payments to employees, estimated forfeiture rates and the accounting policies we adopt concerning the method of recognizing the fair value of awards over the requisite service period.

Reclassifications

Certain other asset items from prior years have been reclassified to conform to the current presentation.

2. Restatement

The Company has restated its previously reported balance sheet as of December 31, 2004. This restatement reflects a correction in the Company’s classification of the short and long term deferred revenues totaling $4,902,000. The restatement of deferred revenues resulted from a clerical error in the classification between long and short term amounts for a contract executed in June 2004 of $4,398,000 and two computational errors totaling $504,000. The following table summarizes the change to the balance sheet at December 31, 2004:

                         
    Previously reported     Adjustment     Restated  
Current liabilities
                       
Deferred revenue
    15,079       4,902       19,981  
Total current liabilities
    20,020       4,902       24,922  
Deferred revenue, long term
    10,705       (4,902 )     5,803  

3. Restructuring, Lease and Asset Impairment Write Downs

In 2004, the Company completed lease termination payments of $1.8 million. There were no other restructuring activities during the year and no accrued restructuring costs as of December 31, 2004.

In October 2003 the Company entered into a lease termination agreement with its landlord to terminate the lease on its Oakland headquarters and entered into a new lease agreement for a reduced amount of space in the same building. The reduction in space is expected to reduce future lease payments by $6.5 million (net of lease termination fees described below) through 2008. Under the lease termination agreement the Company paid an increased security deposit of $550,000 and lease termination fees totaling $490,000 in 2003. A net credit adjustment of $7,000 was charged to operations. The adjustment represented an addition to the restructuring reserve of $350,000 for lease and asset impairment charges, offset by a reduction in deferred rent of $357,000 to account for the reduction in space under the new lease agreement.

In 2002 the Company recorded restructuring, lease and asset impairment charges of $3.4 million in operating expenses. The restructuring resulted in a workforce reduction of approximately 30 employees and a total charge to operations for severance benefits of $1.1 million. All affected employees had been terminated or notified of their severance benefits by December 31, 2002. Most of the employees affected by the workforce reduction were located in the Company’s Oakland office in the marketing and customer service departments.

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Table of Contents

Notes to Financial Statements
3. Restructuring, Lease and Asset Impairment Write Downs (continued)

Due to continued weakness in the commercial real estate market in 2002 the Company recorded an additional charge for excess office space at the Company’s Oakland headquarters of $2.3 million. This charge reflected adjustments to the assumptions on which the 2001 write down for excess office space had been made, including assumptions about the time period that the excess office space would be vacant and potential sublease terms. The Company calculated the estimated costs for the additional facilities restructuring charge based on current market information provided by a commercial real estate broker. We estimated the $3.0 million accrued at December 31, 2002 would be paid over the next two years.

The following table sets forth the restructuring activity during the three years ended December 31, 2004 (in thousands).

                                                                                 
    Accrued                     Accrued                             Accrued             Accrued  
    restructuring                     restructuring                             restructuring             restructuring  
    costs,                     costs,                             costs,             costs,  
    December 31,     Restructuring             December 31,     Restructuring     Asset write-             December 31,             December 31,  
    2001     Charges     Cash paid     2002     Charges     down     Cash paid     2003     Cash paid     2004  
 
Lease obligation
  $ 1,458     $ 2,306     $ (759 )   $ 3,005     $ 154             $ (1,386 )   $ 1,773     $ (1,773 )   $  
Asset write-down
                                  196       (196 )                            
Severance benefits
    82       1,059       (632 )     509                     (509 )                      
 
Total
  $ 1,540     $ 3,365     $ (1,391 )   $ 3,514     $ 350     $ (196 )   $ (1,895 )   $ 1,773     $ (1,773 )   $  
 

4. Prepaid Expenses and Other Current Assets

Prepaid expenses and other current assets consist of the following (in thousands):

                 
    December 31,  
    2004     2003  
     
Prepaid expenses
  $ 1,025     $ 791  
Deferred financing
          232  
Product inventory
    273       109  
Other receivables
    8       12  
     
 
  $ 1,306     $ 1,144  
     

5. Property and Equipment

Property and equipment consists of the following (in thousands):

                 
    December 31,  
    2004     2003  
     
Computer equipment
  $ 4,517     $ 3,978  
Office furniture and equipment
    1,489       1,403  
Leasehold improvements
    453       432  
     
 
    6,459       5,813  
Less accumulated depreciation
    (5,704 )     (5,276 )
     
 
  $ 755     $ 537  
     

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Table of Contents

Notes to Financial Statements (continued)

6. Notes Receivable from Current and Former Officers

Notes receivable from current and former officers was $3.1 million of principal at December 31, 2004 and 2003. The Notes are full recourse loans secured by shares of the Company’s common stock owned by the current and former officers and bear interest at 4.94%. Principal and interest are due December 31, 2005. Principal and accrued interest of $3.7 million and $3.5 million is recorded in Notes and Interest Receivable from Current and Former Officers as of December 31, 2004 and December 31, 2003 respectively.

7. Other Assets

Other Assets consist of the following (in thousands):

                 
    December 31,  
    2,004     2,003  
     
Software development cost
  $ 3,089     $ 3,089  
Less accumulated amortization
    (2,697 )     (2,346 )
     
Software development costs, net
    392       743  
Other non current assets
    875       875  
     
 
  $ 1,267     $ 1,618  
     

8. Accrued Liabilities

Accrued liabilities consist of the following (in thousands):

                 
    December 31,  
    2,004     2,003  
     
Accrued restructuring costs
  $     $ 1,773  
Accrued vacation
    1,036       831  
Accrued commissions and bonus
    2,093       930  
Accounts payable accruals
    671       196  
Other accrued liabilities
    538       145  
     
 
  $ 4,338     $ 3,875  
     

9. Bank Line of Credit

On January 30, 2004 the Company entered into a revolving line of credit agreement with Comerica Bank. The line totaled $7.0 million through July 22, 2004; after that date, the maximum that can be borrowed under the agreement is $5.0 million. The line expires on July 14, 2005. Borrowing under the line of credit bears interest at prime plus 0.5%, currently 5.75%. The facility was partially secured by a letter of credit provided by WPV, Inc., an affiliate of Warburg, Pincus Ventures, a significant stockholder of the Company. The letter of credit was for $4.0 million through May 30, 2004 and $3.0 million from May 31, 2004 to July 30, 2004. The non–guaranteed portion of the line is subject to limitations based on the Company’s accounts receivable balance. To further secure the line the Company granted Comerica a security interest in all of our assets other than our intellectual property, and agreed not to restrict our ability to grant a security interest in our intellectual property. Borrowings under the line are subject to various covenants. There were no borrowings outstanding on the line of credit at December 31, 2004.

In consideration of the original guarantee the Company granted a security interest in substantially all of the Company’s assets and issued WPV, Inc. a fully vested and non-forfeitable warrant to purchase 1,375,000 shares of common stock of the Company at an exercise price of $8.00. The warrant will expire if unexercised by March 9, 2008. The fair value of the warrant at the date of issuance was $3.6 million; this amount was amortized as deferred financing costs by a charge to interest expense through July 31, 2004.

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Table of Contents

Notes to Financial Statements (continued)

10. Income Tax

The Company recorded a tax benefit of $43,000 for the year ended December 31, 2004 relating to the reversal of a provision for U.S. federal alternative minimum tax for the year ended December 31, 2003. The Company has made no provision for U.S. federal, U.S. state or foreign income taxes for the years ended December 31, 2004, 2003 and 2002 as the Company has incurred tax losses in all periods and for all jurisdictions.

Deferred income taxes reflect the net tax effects of temporary differences between carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company’s deferred tax assets are as follows, (in thousands):

                 
    December 31,  
    2004     2003  
     
Deferred tax assets:
               
Net operating loss carryforwards
  $ 27,637     $ 26,272  
Restructuring reserve
          710  
Capitalized software and development costs
    389       698  
Deferred revenue
    395       1,008  
Research credit carryforwards
    1,195       811  
Other
    1,360       941  
 
               
     
Total deferred tax assets
    30,976       30,440  
Valuation allowance
    (30,976 )     (30,440 )
     
 
               
Net deferred tax assets
  $     $  
     

Realization of deferred tax assets is dependent upon future earnings, if any, the timing and amount of which are uncertain. Accordingly, the net deferred tax assets have been fully offset by a valuation allowance. The valuation allowance decreased from December 31, 2002 to December 31, 2003 in the amount of $357,000.

As of December 31, 2004, the Company had net operating loss carryforwards for federal income tax purposes of approximately $77,286,000, which expire in the years 2011 through 2024 and federal research tax credits of approximately $823,000, which expire in the years 2011 through 2024. The Company also had net operating loss carryforwards for state income tax purposes of approximately $30,315,000 expiring in the years 2006 through 2014 and state research tax credits of approximately $372,000 which carry forward indefinitely.

Utilization of the company’s net operating loss carryforwards may be subject to substantial annual limitation due to the ownership change limitation provided by the Internal Revenue Code and a similar state provision. Such an annual limitation could result in the expiration of the net operating loss carryforwards before utilization.

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Table of Contents

Notes to Financial Statements (continued)

11. Stockholders’ Deficit

Common Stock

At December 31, 2004, the Company had reserved shares of common stock for future issuance as follows:

         
Stock Options outstanding
    3,103,102  
Stock Options available for future grants
    1,026,439  
Employee stock purchase plan
    225,675  
Common stock warrants
    1,375,000  
 
     
 
    5,730,216  
 
     

Stock Options

The Company’s employee stock option plans provide for the issuance of incentive stock options (ISO), nonstatutory stock options (NSO) and stock awards to eligible participants. The ISOs may be granted at a price per share not less than the fair market value at the date of grant. The NSOs may be granted at a price per share not less than 85% of the fair market value at the date of grant. Certain options previously granted can be exercised prior to vesting, but, if so exercised, these unvested shares are subject to repurchase by the Company. Options and unvested shares granted generally vest over a period of four years. Options under the employee plans have a maximum term of ten years. In the event option holders cease to be employed by the Company, all unvested options are forfeited and all vested options may be exercised within a 90-day period after termination. The 90-day exercise period is sometimes extended by agreement with the optionee, which could result in a modification charge to operations.

In May 1999, the Company’s stockholders approved the 1999 Equity Incentive Plan, which amended and restated the Company’s previous stock option plan. 3,292,666 shares of common stock were authorized for issuance under the plan, including shares originally authorized under predecessor plans and shares added to the plan in 2001. In May 2002, the Company’s Board of Directors approved and in May 2003, the shareholders subsequently approved, adding 1,350,000 shares to the 1999 Equity Incentive Plan. In January 2004, the Company’s Board of Directors approved and in June 2004, the shareholders subsequently approved, adding an additional 850,000 shares to the 1999 Equity Plan. The total number of shares authorized for issuance under the plan is now 5,492,666. The Board of Directors also approved the 2002 CEO Stock Option Plan in May 2002, which was subsequently approved by the shareholders in May 2003. This plan reserved an aggregate of 470,588 shares for grants of stock options under the plan.

In May 1999, the Company’s stockholders approved the 1999 Non-Employee Directors’ Stock Option Plan and reserved an aggregate of 75,000 shares of common stock for grants of stock options under the plan. In May 2003, the Company’s stockholders approved an increase in the number of shares authorized for issue under the plan from 75,000 shares to a total of 150,000 shares.

The Company has, on occasion, granted stock options and stock to non-employees and directors. A compensation charge has been recorded in these instances. In 2004 10,797 shares were issued to directors as payment for their services; an expense of $71,000 was recorded for the year ended December 31, 2004.

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Table of Contents

Notes to Financial Statements
11. Stockholders’ Deficit (continued)

A summary of the Company’s stock option activity under the plans is as follows:

                 
    Outstanding Options  
            Weighted-Average Exercise  
    Number of Shares     Price Per Share  
     
Outstanding at December 31, 2001
    1,653,166     $ 9.47  
Granted
    2,239,290       1.36  
Exercised
    (274,471 )     1.15  
Canceled
    (628,681 )     9.35  
 
             
Outstanding at December 31, 2002
    2,989,304       4.20  
Granted
    501,834       3.08  
Exercised
    (207,445 )     1.27  
Canceled
    (238,666 )     9.85  
 
             
Outstanding at December 31, 2003
    3,045,027       3.76  
Granted
    552,497       5.71  
Exercised
    (417,773 )     1.54  
Canceled
    (76,739 )     7.88  
 
             
Outstanding at December 31, 2004
    3,103,012     $ 4.33  
 
             
 
               
Vested and exercisable
    1,407,373          
 
             

The following table summarizes information concerning outstanding and exercisable stock options at December 31, 2004:

                                         
    Outstanding     Vested and Exercisable  
                    Weighted-             Weighted  
                    Average             Average  
            Weighted-     Remaining             Exercise  
    Number of     Average Exercise     Contractual Life     Number of     Price Per  
Price Range   Shares     Price Per Share     (Years)     Shares     Share  
     
$0.2600 – $1.3900
    1,141,600     $ 1.37       7.35       185,349     $ 1.30  
$1.4000 – $6.1250
    1,539,098     $ 4.03       7.60       846,464     $ 3.70  
$6.2500 – $39.8750
    422,314     $ 13.42       5.58       375,560     $ 14.29  
 
                                   
 
    3,103,012                       1,407,373          
 
                                   

Common Stock Warrants

In 2001, the Company issued a fully vested non-forfeitable warrant to purchase 1,375,000 shares of common stock of the Company at an exercise price of $8.00 per share. The warrant was issued to WPV, Inc., an affiliate of a significant stockholder of the Company, in connection with the guarantee of a line of credit to the Company. The warrant is outstanding and will expire if unexercised by March 9, 2008. The fair value of the warrant at the date of issuance was $3.6 million. The value of the warrant was determined using the Black-Scholes model with the following assumptions: a share price of $3.88, volatility of .85, a risk-free interest rate of 4.94%, no dividend yield and an expected life of seven years.

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Notes to Financial Statements
11. Stockholders’ Deficit (continued)

1999 Employee Stock Purchase Plan

In May 1999 the stockholders approved the 1999 Employee Stock Purchase Plan, which became effective upon the completion of the initial public offering of the Company’s common stock. The Company initially reserved a total of 350,000 shares of common stock for issuance under the plan. In May 2002 the Company’s shareholders approved an additional 350,000 shares for a total of 700,000 shares. Eligible employees may purchase common stock at 85% of the lesser of the fair market value of the Company’s common stock on the first day of the applicable one-year offering period or the last day of the applicable six-month purchase period. The Company issued 78,468 and 52,912 shares of common stock under the plan during the years ended December 31, 2004 and 2003, respectively. At December 31, 2004, 225,675 shares were available for issuance under the Plan.

12. Commitments

Leases

The Company leases its corporate office facility under a non-cancelable operating lease with a term expiring in 2013. Future minimum payments under this lease as of December 31, 2004 are as follows (in thousands):

         
2005
  $ 940  
2006
    940  
2007
    940  
2008
    940  
2009
    984  
2010 and thereafter
    4,423  
 
     
 
  $ 9,167  
 
     

Rent expense under all operating leases net of sublease income was $1 million, $1 million and $1.7 million for the years ended December 31, 2004, 2003 and 2002, respectively.

License Agreement

In September 1996, the Company entered into a license agreement with a university for the use of the intellectual property underlying its most significant current products. In exchange for the license, which expires in 2014, the Company issued stock and paid a license-issue fee. The agreement also provided for milestone payments, all of which have been made, and for royalties based on sales of products using the licensed technology. Royalty expenses were $746,000, $898,000 and $723,000 for the years ended December 31, 2004, 2003 and 2002, respectively, and are included in cost of revenues. Annual minimum guaranteed royalty payments are $150,000.

If the Company loses or is unable to maintain the license agreement during the term of the underlying patents, it would materially harm its business. The university may terminate the license agreement if the Company fails to perform or violates its terms without curing the violation within 60 days of receiving written notice of the violation.

13. Warranties; Indemnification

The Company generally provides a warranty that its software products substantially operate as described in the manuals and guides that accompany the software for a period of 90 days. The warranty does not apply in the event of misuse, accident, and certain other circumstances. To date, the Company has not incurred any material costs associated with these warranties and has no accrual for such items at December 31, 2004.

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Notes to Financial Statements
13. Warranties; Indemnification (continued)

From time to time, the Company enters into contracts that require the Company, upon the occurrence of certain contingencies, to indemnify parties against third party claims. These contingent obligations primarily relate to (i) claims against the Company’s customers for violation of third party intellectual property rights caused by the Company’s products; (ii) claims resulting from personal injury or property damage resulting from the Company’s activities or products; (iii) claims by the Company’s office lessor arising out of the Company’s use of the premises; and (iv) agreements with the Company’s officers and directors under which the Company may be required to indemnify such persons for liabilities arising out of their activities on behalf of the Company. Because the obligated amounts for these types of agreements usually are not explicitly stated, the overall maximum amount of these obligations cannot be reasonably estimated. No liabilities have been recorded for these obligations on the Company’s balance sheet as of December 31, 2004 or 2003.

14. Employee Retirement and Benefit Plan

The Company has a defined contribution retirement plan under Section 401(k) of the Internal Revenue Code, which covers substantially all employees. Eligible employees may contribute amounts to the plan, via payroll withholding, subject to certain limitations. The Company does not presently match contributions by plan participants.

15. Related Party Transaction

On September 30, 2003 the Company entered into an agreement with Posit Science Corporation (“PSC”), formerly Neuroscience Solutions Corporation, to provide PSC with exclusive rights in the healthcare field to certain intellectual property, patents and software owned or licensed by the Company, along with transfer of certain healthcare research projects. A co-founder, substantial shareholder, and member of the Board of Directors of the Company is a co-founder, officer, director and substantial shareholder of PSC.

The rights were acquired by PSC for a combination of cash, stock and future royalties. PSC paid $500,000 cash, of which $448,000 was recognized at December 31, 2003. The balance will be recognized over the next nine months as services are provided to PSC. Amounts received to date and any future receipts are being reported as other income as the Company does not consider the sale of these rights to be part of its recurring operations. Under the agreement, the Company will receive net royalties between 2% to 4% on products sold by PSC that use the Company’s patents or software. We did not record a value for the 1.8 million shares of PSC received in the transaction, because PSC was a private start-up venture, the shares of which had no determinable value.

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Notes to Financial Statements (continued)

16. Interim Financial Information (unaudited)

Quarterly financial data (in thousands, except per share amounts)

                                         
    2004  
                    Quarter ended              
    March 31     June 30     September 30     December 31     Total  
     
Total revenues
  $ 7,036     $ 7,497     $ 8,290     $ 8,153     $ 30,976  
 
                                       
Gross profit
    5,477       5,803       6,512       6,428       24,220  
 
                                       
Net income (loss)
    (290 )     (52 )     667       (1,018 )     (693 )
 
                                       
Net income (loss) per share:
                                       
Basic
    (0.02 )     0.00       0.04       (0.06 )     (0.04 )
 
                                       
Diluted
    (0.02 )     0.00       0.04       (0.06 )     (0.04 )
                                         
    2003  
                    Quarter ended              
    March 31     June 30     September 30     December 31     Total  
     
Total revenues
  $ 6,583     $ 8,074     $ 8,293     $ 6,966     $ 29,916  
 
                                       
Gross profit
    5,158       6,630       6,724       5,405       23,917  
 
                                       
Net income (loss)
    (454 )     745       1,678       161       2,130  
 
                                       
Net income (loss) per share:
                                       
Basic
    (0.03 )     0.05       0.10       0.01       0.13  
 
                                       
Diluted
    (0.03 )     0.04       0.10       0.01       0.13  

The Company has restated its previously reported balance sheets as of June 30 and September 30, 2004. This restatement reflects a correction in the Company’s classification of short and long term deferred revenues totaling $4,398,000 as of June 30, 2004 and $4,615,000 as of September 30, 2004. As of June 30, 2004, the restatement of deferred revenues resulted from a clerical error in the classification between long and short term amounts for a contract executed in June 2004. As of September 30, 2004, the restatement of deferred revenues resulted from a clerical error in the classification of the same contract and a computation error.

The following table summarizes the change to the balance sheet at September 30, 2004:

                         
    Previously reported     Adjustment     Restated  
Current liabilities
                       
Deferred revenue
    14,883       4,615       19,498  
Total current liabilities
    18,539       4,615       23,154  
Deferred revenue, long term
    10,842       (4,615 )     6,227  

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Notes to Financial Statements
16. Interim Financial Information (unaudited) (continued)

The following table summarizes the change to the balance sheet at June 30, 2004:

                         
    Previously reported     Adjustment     Restated  
Current liabilities
                       
Deferred revenue
    15,548       4,398       19,946  
Total current liabilities
    22,615       4,398       27,013  
Deferred revenue, long term
    11,990       (4,398 )     7,592  

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ITEM 9A. CONTROLS AND PROCEDURES

Disclosure controls and procedures are designed to ensure that information required to be disclosed in our reports filed under the Exchange Act, such as this Annual Report on Form 10-K/A, is recorded, processed, summarized and reported within the required time periods. These procedures are also designed to ensure that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

In connection with the Original Form 10-K, as required under Rule 13a-15(b) of the Exchange Act, the Company’s management, including the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the Company’s disclosure controls and procedures. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded in the Original Form 10-K that the Company’s disclosure controls and procedures were not effective as of December 31, 2004. This determination was based on need to correct the Company’s revenue recognition method that that led to the restatement of the Company’s historical financial statements from 2000 through June 30, 2004. This restatement was effected by through filings with the SEC on February 15, 2005.

The Original Form 10-K was filed on April 15, 2005. In May 2005, in the course of preparing the first quarter 2005 financial statements, the Company’s management determined that the balance sheets at June 30, September 30, and December 31, 2004 incorrectly classified a portion of deferred revenue as long term deferred revenue when it should have been classified as current deferred revenue. As a result, the Company’s management and the Audit Committee of the Company’s Board of Directors concluded that the Company should, and in this filing the Company has, restated its balance sheet at December 31, 2004.

As a result of these circumstances, management has concluded that there is a material weakness in the Company’s internal controls, as defined by the Public Company Accounting Oversight Board.

As required under Rule 13a-15(b) of the Exchange Act, the Company’s management, including the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this report. Because of the revenue and deferred revenue issues discussed above, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were not effective as of December 31, 2004. We are committed to implementing changes in our internal controls over financial reporting with respect to revenue and deferred revenue. We have hired additional accounting staff and we are in the process of evaluating what changes should be made in our controls. Except for these changes, during the year ended December 31, 2004, there were no changes in the Company’s internal controls over financial reporting that materially affected, or are reasonably likely to materially affect the Company’s internal control over financial reporting.

It should be noted that a control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. As a result, there can be no assurance that a control system will succeed in preventing all possible instances of error and fraud. The Company’s disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives, and the conclusions of our Chief Executive Officer and the Chief Financial Officer are made at the “reasonable assurance” level.

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PART IV

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

     (a) Documents filed as part of this report:

(1) Financial Statements

Independent Registered Public Accounting Firm’s Report
Restated Balance Sheet – December 31, 2004 and 2003
Statement of Operations – Years Ended December 31, 2004, 2003 and 2002
Statements of Stockholders’ (Deficit) Equity – Years Ended December 31, 2004, 2003 and 2002
Restated Statement of Cash Flows – Years Ended December 31, 2004, 2003 and 2002
Notes to the Financial Statements

(2) Financial Statement Schedules

As required under Item 8, Financial Statements and Supplementary Data, the financial statement schedule of the Company is provided in this separate section. The financial statement schedule included in this section is as follows:

Schedule II – Valuation and Qualifying Accounts
(in thousands)

Valuation and Qualifying Accounts which are deducted in the Balance Sheet from the assets to which they apply:

Allowance for Doubtful Accounts Years Ended December 31

                                         
            Charges to             Additions        
    Opening     Operating     Charges to     (deductions) to     Closing  
    Balance     Expenses     Allowance     Allowance     Balance  
2004
  $ 139     $ (3 )   $ (100 )   $ 85     $ 121  
2003
    270             89       (220 )     139  
2002
    248       19       309       (306 )     270  

(3) Exhibits

     
Exhibit No.   Description of Document
23.1
  Consent of Ernst & Young, LLP, Independent Registered Public Accounting Firm
 
   
31.1
  Certification of Chief Executive Officer (Section 302)
 
   
31.2
  Certification of Chief Financial Officer (Section 302)
 
   
32.1
  Certification of Chief Executive Officer (Section 906)
 
   
32.2
  Certification of Chief Financial Officer (Section 906)

     (b) Reports on Form 8-K.

On October 1, 2003, the Company filed a Report on Form 8-K disclosing the closing under a technology transfer agreement with Neuroscience Solutions Corporation.

On October 3, 2003, the Company filed a Report on Form 8-K disclosing its agreement to reduce the amount available for borrowing under its credit line.

On October 30, 2003, the Company filed a Report on Form 8-K furnishing its press release announcing its financial results for the quarter ended September 30, 2003 and the transcript of its conference call discussing those earnings.

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SIGNATURES

          Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

SCIENTIFIC LEARNING CORPORATION

         
By /s/ Robert C. Bowen   May 25, 2005                              
     
  Robert C. Bowen    
  Chief Executive Officer    

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

         
SIGNATURES   TITLE   DATE
 
/s/ Robert C. Bowen
       
Robert C. Bowen
  Chairman, Chief Executive Officer and Director (Principal Executive Officer)   May 25, 2005
 
       
/s/ Jane A. Freeman
       
Jane A. Freeman
  Senior Vice President, Chief Financial Officer, and Treasurer (Principal Financial and Accounting Officer)   May 25, 2005
 
       
/s/ Dr. Michael M. Merzenich
       
Dr. Michael M. Merzenich
  Director   May 25, 2005
 
       
/s/ Dr. Paula A. Tallal
       
Dr. Paula A. Tallal
  Director   May 25, 2005
 
       
/s/ Carleton A. Holstrom
       
Carleton A. Holstrom
  Director   May 25, 2005
 
       
/s/ Rodman W. Moorhead, III
       
Rodman W. Moorhead, III
  Director   May 25, 2005
 
       
/s/ Ajit Dalvi
       
Ajit Dalvi
  Director   May 25, 2005
 
       
/s/ Dr. Joseph Martin
       
Dr. Joseph Martin
  Director   May 25, 2005
 
       
/s/ Edward Vermont Blanchard, Jr.
       
Edward Vermont Blanchard, Jr.
  Director   May 25, 2005
 
       
/s/ David W. Smith
       
David W. Smith
  Director   May 25, 2005

 


Table of Contents

Index to Exhibits

     
Exhibit No.   Description of Document
23.1
  Consent of Ernst & Young, LLP, Independent Registered Public Accounting Firm
 
   
31.1
  Certification of Chief Executive Officer (Section 302)
 
   
31.2
  Certification of Chief Financial Officer (Section 302)
 
   
32.1
  Certification of Chief Executive Officer (Section 906)
 
   
32.2
  Certification of Chief Financial Officer (Section 906)

 

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