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Scientific Learning 10-Q 2006

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. Ex-32.2
  6. Ex-32.2


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

FORM 10-Q

 

 

x  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2006

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 number 000-24547

Scientific Learning Corporation
(Exact name of registrant as specified in its charter)

 

 

 

Delaware

 

94-3234458

(State or other jurisdiction of incorporation or organization)

 

(I.R.S. Employer Identification No.)

300 Frank H. Ogawa Plaza, Suite 600
Oakland, California 94612
(510) 444-3500

(Address of Registrants principal executive offices, including zip code, and
telephone number, including area code)

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

          Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act (Check one):

Large accelerated filer o   Accelerated filer o   Non-accelerated filer x

          Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  o     No  x

          As of April 15, 2006, there were 16,794,909 shares of Common Stock outstanding.



SCIENTIFIC LEARNING CORPORATION

INDEX TO FORM 10-Q
FOR THE QUARTER ENDED March 31, 2006

 

 

 

 

 

 

 

PAGE

PART 1. FINANCIAL INFORMATION

 

 

 

 

 

Item 1.

Financial Statements (Unaudited):

 

 

 

 

 

 

 

Condensed Balance Sheets

 

3

 

 

 

 

 

Condensed Statements of Operations

 

4

 

 

 

 

 

Condensed Statements of Cash Flows

 

5

 

 

 

 

 

Notes to Condensed Financial Statements

 

6

 

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

13

 

 

 

 

Item 3.

Quantitative and Qualitative Disclosures about Market Risk

 

21

 

 

 

 

Item 4.

Controls and Procedures

 

21

 

 

 

 

PART II. OTHER INFORMATION

 

 

 

 

 

Item 1.

Legal Proceedings

 

22

 

 

 

 

Item1A

Risk Factors

 

22

 

 

 

 

Item 6.

Exhibits

 

29

 

 

 

 

 

Signature

 

30

Page 2


PART I.  FINANCIAL INFORMATION

Item 1. Financial Statements

 

SCIENTIFIC LEARNING CORPORATION

CONDENSED BALANCE SHEETS

(In thousands)

Unaudited


 

 

 

 

 

 

 

 

 

 

March 31,
2006

 

December 31,
2005

 

 

 


 


 

Assets

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

8,196

 

$

9,022

 

Short-term investments

 

 

 

 

3,043

 

Accounts receivable, net

 

 

5,149

 

 

3,519

 

Notes and interest receivable from current and former officers

 

 

 

 

297

 

Prepaid expenses and other current assets

 

 

1,333

 

 

1,312

 

 

 



 



 

 

 

 

 

 

 

 

 

Total current assets

 

 

14,678

 

 

17,193

 

 

 

 

 

 

 

 

 

Property and equipment, net

 

 

624

 

 

469

 

Other assets

 

 

996

 

 

1,072

 

 

 



 



 

 

 

 

 

 

 

 

 

Total assets

 

$

16,298

 

$

18,734

 

 

 



 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Liabilities and stockholders’ deficit

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

Accounts payable

 

$

221

 

$

214

 

Accrued liabilities

 

 

3,428

 

 

2,966

 

Deferred revenue

 

 

10,944

 

 

11,171

 

 

 



 



 

 

 

 

 

 

 

 

 

Total current liabilities

 

 

14,593

 

 

14,351

 

Deferred revenue, long-term

 

 

5,012

 

 

5,832

 

Other liabilities

 

 

379

 

 

386

 

 

 



 



 

 

 

 

 

 

 

 

 

Total liabilities

 

 

19,984

 

 

20,569

 

 

 

 

 

 

 

 

 

Stockholders’ deficit:

 

 

 

 

 

 

 

Common stock and additional paid-in capital

 

 

76,588

 

 

76,265

 

Accumulated deficit

 

 

(80,274

)

 

(78,100

)

 

 



 



 

 

 

 

 

 

 

 

 

Total stockholders’ deficit:

 

 

(3,686

)

 

(1,835

)

 

 



 



 

 

 

 

 

 

 

 

 

Total liabilities and stockholders’ deficit

 

$

16,298

 

$

18,734

 

 

 



 



 

See accompanying notes

Page 3



 

SCIENTIFIC LEARNING CORPORATION
CONDENSED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
Unaudited


 

 

 

 

 

 

 

 

 

 

Three months ended March 31,

 

 

 


 

 

 

2006

 

2005

 

 

 


 


 

 

Revenues:

 

 

 

 

 

 

 

Products

 

$

5,348

 

$

7,833

 

Service and support

 

 

2,483

 

 

2,412

 

 

 



 



 

Total revenues

 

 

7,831

 

 

10,245

 

 

 

 

 

 

 

 

 

Cost of revenues:

 

 

 

 

 

 

 

Cost of products

 

 

320

 

 

433

 

Cost of service and support

 

 

1,849

 

 

1,360

 

 

 



 



 

Total cost of revenues

 

 

2,169

 

 

1,793

 

 

 



 



 

 

 

 

 

 

 

 

 

Gross profit

 

 

5,662

 

 

8,452

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

Sales and marketing

 

 

5,379

 

 

4,763

 

Research and development

 

 

1,022

 

 

933

 

General and administrative

 

 

1,567

 

 

1,537

 

 

 



 



 

 

 

 

 

 

 

 

 

Total operating expenses

 

 

7,968

 

 

7,233

 

 

 



 



 

 

 

 

 

 

 

 

 

Operating income (loss)

 

 

(2,306

)

 

1,219

 

 

 

 

 

 

 

 

 

Other income from related party

 

 

37

 

 

12

 

Interest income, net

 

 

95

 

 

85

 

 

 



 



 

 

 

 

 

 

 

 

 

Income (loss) before income tax

 

 

(2,174

)

 

1,316

 

 

Income tax provision

 

 

 

 

26

 

 

 



 



 

Net income (loss)

 

$

(2,174

)

$

1,290

 

 

 



 



 

 

 

 

 

 

 

 

 

Basic net income (loss) per share

 

$

(0.13

)

$

0.08

 

 

 



 



 

Shares used in computing basic net income (loss) per share

 

 

16,797,451

 

 

16,663,645

 

 

 



 



 

Diluted net income (loss) per share

 

$

(0.13

)

$

0.07

 

 

 



 



 

Shares used in computing diluted net income (loss) per share

 

 

16,797,451

 

 

17,670,769

 

 

 



 



 

See accompanying notes

Page 4



 

SCIENTIFIC LEARNING CORPORATION

CONDENSED STATEMENTS OF CASH FLOWS

(In thousands)

Unaudited


 

 

 

 

 

 

 

 

 

 

Three months ended March 31,

 

 

 


 

 

 

2006

 

2005

 

 

 


 


 

 

Operating Activities:

 

 

 

 

 

 

 

Net income (loss)

 

$

(2,174

)

$

1,290

 

Adjustments to reconcile net income to cash provided by operating activities:

 

 

 

 

 

 

 

Depreciation and amortization

 

 

97

 

 

183

 

Increase in interest receivable from current and former officers

 

 

 

 

(11

)

Stock based compensation

 

 

381

 

 

94

 

Changes in operating assets and liabilities:

 

 

 

 

 

 

 

Accounts receivable

 

 

(1,630

)

 

1,971

 

Prepaid expenses and other current assets

 

 

(21

)

 

66

 

Other assets

 

 

11

 

 

 

Accounts payable

 

 

7

 

 

(144

)

Accrued liabilities

 

 

462

 

 

(1,418

)

Deferred revenue

 

 

(1,047

)

 

(5,518

)

Other liabilities

 

 

(7

)

 

10

 

 

 



 



 

 

Net cash used in operating activities

 

 

(3,921

)

 

(3,477

)

 

Investing Activities:

 

 

 

 

 

 

 

Purchases of property and equipment, net

 

 

(187

)

 

(87

)

Maturity of investments

 

 

3,043

 

 

 

Repayment on current and former officer loans

 

 

213

 

 

 

 

 



 



 

 

Net cash provided by (used in) investing activities

 

 

3,069

 

 

(87

)

 

Financing Activities:

 

 

 

 

 

 

 

Proceeds from issuance of common stock, net

 

 

26

 

 

75

 

 

 



 



 

 

Net cash provided by financing activities

 

 

26

 

 

75

 

 

 



 



 

 

Decrease in cash and cash equivalents

 

 

(826

)

 

(3,489

)

 

 

 

 

 

 

 

 

Cash and cash equivalents at beginning of period

 

 

9,022

 

 

10,281

 

 

 



 



 

 

 

 

 

 

 

 

 

Cash and cash equivalents at end of period

 

$

8,196

 

$

6,792

 

 

 



 



 

 

 

 

 

 

 

 

 

See accompanying notes.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Supplemental schedule of noncash financing activities:

 

 

 

 

 

 

 

Common stock surrendered in connection with repayment of officer loans

 

$

84

 

 

 

Page 5


Notes to Condensed Financial Statements

1. Summary of Significant Accounting Policies

Description of Business

Scientific Learning Corporation provides neuroscience-based software products that build learning capacity by developing the underlying cognitive skills required for reading and learning. We operate in one operating segment. Our 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. We also sell 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.

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. To the extent that there are material differences between these estimates and actual results, our financial statements could be affected.

Interim Financial Information

The interim financial information as of March 31, 2006 and for the three months ended March 31, 2006 and 2005 is unaudited, but includes all normal recurring adjustments that we consider necessary for a fair presentation of our financial position at such date and our results of operations and cash flows for those periods.

As discussed in Note 2, we adopted Statement of Financial Accounting Standards (SFAS) No. 123R, “Share-Based Payment,” on January 1, 2006 using the modified prospective transition method. Accordingly, our operating loss before income taxes for the three months ended March 31, 2006 includes approximately $381,000 in share-based employee compensation expense for stock options, restricted stock units and our Employee Stock Purchase Plan. Because we elected to use the modified prospective transition method, results for prior periods have not been restated.

These condensed financial statements and notes should be read in conjunction with our audited financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations, contained in our Annual Report on Form 10-K for the year ended December 31, 2005, filed with the Securities and Exchange Commission.

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 exists; 2) delivery of the product has occurred; 3) a fixed or determinable fee; and 4) the probability that the fee will be collected. The application of SOP 97-2 requires us to exercise significant judgment related to our specific transactions and transaction types.

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). We allocate revenue to each element of a transaction based upon its fair value as determined in reliance on “vendor specific objective evidence” (“VSOE”), if VSOE exists for each element. As we do not have VSOE for software licenses, we normally recognize revenue using the residual method on arrangements with multiple elements that include software licenses, whereby the difference between the total arrangement fee and the total fair value of the undelivered elements (generally services and support) is recognized as revenue relating to software licenses. 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. We are

Page 6


Notes to Condensed Financial Statements

1. Summary of Significant Accounting Policies (continued)

required to exercise judgment in determining whether VSOE exists for each undelivered element based on whether our pricing for these elements is sufficiently consistent.

The value of software licenses, services and support invoiced during a particular period is recorded as deferred revenue until recognized. All revenue from transactions that include new products that have not yet been delivered is deferred until the delivery of all products. Deferred revenue is recognized as revenue as discussed below.

Product revenue

Product revenue is primarily derived from the licensing of software and 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.

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

We consider all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. Cash and cash equivalents, which primarily consist of cash on deposit with banks, money market funds, and US Government debt with a maturity of three months or less, are stated at cost, which approximates fair value.

Short-Term Investments

We determine the appropriate classification of investments at the time of purchase in accordance with Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and reevaluate such determination at each balance sheet date. In August 2005 we purchased $2,999,000 in debt securities issued by the U.S. Treasury that matured in February 2006. We classified this investment as held-to-maturity and at December 31, 2005 it was stated at an amortized cost of $3,043,000. The carrying value of short-term investments approximates fair value due to their short-term nature.

Page 7


Notes to Condensed Financial Statements

1. Summary of Significant Accounting Policies (continued)

Other Assets

Other assets consist of the following (in thousands):

 

 

 

 

 

 

 

 

 

 

March 31,
2006

 

December 31,
2005

 

 

 


 


 

Software development costs

 

$

3,089

 

$

3,089

 

Less accumulated amortization

 

 

(3,024

)

 

(2,959

)

 

 



 



 

Software development costs, net

 

 

65

 

 

130

 

Other non current assets

 

 

931

 

 

942

 

 

 



 



 

 

 

$

996

 

$

1,072

 

 

 



 



 

Included in other non current assets at March 31, 2006 and December 31, 2005 was a long term deposit of $850,000 relating to the lease of our primary facility.

Net Income (Loss) 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 is computed using the weighted average number of common shares outstanding during the period and, when dilutive, includes potential common shares from options and warrants calculated using the treasury stock method.

2. Stock-Based Compensation

Stock-Based Compensation Plans

On March 31, 2006, we had four active share-based compensation plans, which are described below.

In May 1999, our stockholders approved our 1999 Equity Incentive Plan. The total number of shares authorized for issuance under the plan is 5,492,666. Option awards have generally been granted with an exercise price equal to the market price of our common stock at the date of grant, and generally vest based on four years of continuous service with a ten-year contractual term. Restricted stock units awarded under this plan generally vest over four years of continuous service in annual or semi-annual installments.

In May 1999, our stockholders approved the 1999 Non-Employee Directors’ Stock Option Plan. The total number of shares authorized for issuance under this plan is 250,000.

In May 2002, the Board of Directors approved the 2002 CEO Stock Option Plan, which was subsequently approved by the shareholders in May 2003. The total number of shares authorized for issuance under this plan is 470,588.

In May 1999 the stockholders approved the 1999 Employee Stock Purchase Plan (ESPP), which became effective upon the completion of the initial public offering of our common stock. The total number of shares authorized for issuance under the plan is 700,000. Eligible employees may purchase common stock at 85% of the lesser of the fair market value of our common stock on the first day of the applicable one-year offering period or the last day of the applicable six-month purchase period. At March 31, 2006, 166,880 shares were available for issuance under this plan.

Adoption of SFAS No. 123R

Prior to January 1, 2006, we accounted for our stock plans under the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB No. 25). We adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (“SFAS No. 123R”), effective January 1, 2006

Page 8


Notes to Condensed Financial Statements

2. Stock-Based Compensation (continued)

using the modified prospective transition method. Under that transition method, stock-based compensation expense recognized during the quarter ended March 31, 2006 includes: (a) stock options granted prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the original provisions of SFAS No. 123, and (b) stock options and restricted stock units granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123R. Under the modified prospective transition method, results for prior periods are not restated.

SFAS No. 123R requires us to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest. For purposes of calculating pro forma information under SFAS 123 for periods prior to January 1, 2006, we accounted for forfeitures as they occurred.

In anticipation of the adoption of SFAS No. 123R, we did not modify the terms of any previously granted options. We made minor changes to our equity compensation program by reducing the overall number of shares covered by equity compensation grants and granting restricted stock units beginning in Q1 2006.

As a result of adopting SFAS No. 123R using the modified prospective method, our loss from continuing operations before income taxes and net loss for the first quarter of fiscal 2006 includes approximately $381,000 of stock-based compensation expense.

The following table presents the pro forma effect on net income and net income per share if we had applied the fair value recognition provisions of SFAS No. 123 to options granted under our share-based compensation arrangements during the first quarter of fiscal 2005:

 

 

 

 

 

(In thousands, except per share amounts)

 

Three months
ended

March 31,
2005

 

 

 


 

 

Net income, as reported

 

$

1,290

 

Add: Share-based compensation expense included in reported net income, net of related tax effects

 

 

94

 

Deduct: Total share-based compensation expense determined under the fair value based method for all awards, net of related tax effects

 

 

(432

)

 

 



 

Net income, pro forma

 

$

952

 

 

 



 

 

 

 

 

 

Basic net income per share - as reported

 

$

0.08

 

Basic net income per share - pro forma

 

$

0.06

 

Diluted net income per share - as reported

 

$

0.07

 

Diluted net income per share - pro forma

 

$

0.05

 

For purposes of this pro forma disclosure, we estimated the value of the options using the Black-Scholes option valuation model and amortized the fair value of options granted to expense over the option vesting period.

Compensation Cost

The compensation cost that has been charged against our results of operations was as follows for the first quarter of fiscal 2006 (in thousands):

Page 9


Notes to Condensed Financial Statements

2. Stock-Based Compensation (continued)

 

 

 

 

 

Share-based compensation cost included in:

 

 

 

 

Cost of service and support revenues

 

$

40

 

Sales and marketing

 

 

138

 

Research and development

 

 

62

 

General and administrative

 

 

141

 

 

 



 

Total share-based compensation cost

 

$

381

 

 

Income tax benefit recognized

 

 

 

 

 

 



 

 

 

$

381

 

 

 



 

Valuation of Stock Option Awards

The fair value of each option award is estimated on the date of grant using the Black-Scholes option valuation model. This model requires the input of highly subjective assumptions, including expected stock price volatility, and the estimated life of each award and estimated pre-vesting forfeitures. The fair value of these stock options was estimated assuming no expected dividends and estimates of expected life, volatility and risk-free interest rate at the time of grant. We recognize compensation expense for the fair values of these awards, which have graded vesting, on a straight-line basis over the requisite service period of each of these awards.

There were no stock options granted in the three-month period ended March 31, 2006. The fair value of stock options granted in the three-month period ended March 31, 2005 was estimated using the following weighted-average assumptions:

 

 

 

 

 

 

 

Three months ended
March 31, 2005

 

 

 


 

Risk-free interest rate

 

3.4

%

 

Expected volatility

 

106.0

%

 

Expected life (in years)

 

4.0

 

 

Dividend yield

 

0.0

%

 

Summary of Stock Options

The following table summarizes all stock option activity under our share-based compensation plans for the three months ending March 31, 2006:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Outstanding Options

 

 

 


 

 

 

Shares

 

Weighted-
Average
Exercise
Price

 

Weighted-
Average
Remaining
Contractual
Term (Years)

 

Aggregate
Intrinsic
Value

 

 

 


 


 


 


 

Outstanding at December 31, 2005

 

 

3,380,325

 

$

4.26

 

 

 

 

 

 

 

Granted

 

 

 

 

 

 

 

 

 

 

 

Exercised

 

 

(7,382

)

$

3.47

 

 

 

 

 

 

 

Forfeited or expired

 

 

(51,353

)

$

5.23

 

 

 

 

 

 

 

 

 



 

 

 

 

 

 

 

 

 

 

 

Outstanding at March 31, 2006

 

 

3,321,590

 

$

4.25

 

 

6.54

 

$

5,376,065

 

 

 



 



 



 



 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Exercisable at March 31, 2006

 

 

1,858,413

 

$

5.02

 

 

6.01

 

$

2,563,271

 

 

 



 



 



 



 

Page 10


Notes to Condensed Financial Statements

2. Stock-Based Compensation (continued)

Aggregate intrinsic value of options outstanding at March 31, 2006 is calculated as the difference between the exercise price of the underlying options and the market price of our common stock for the 1,903,362 shares that had exercise prices that were lower than the $4.75 market price of our common stock at March 31, 2006 (“in the money options”). The total intrinsic value of options exercised during the quarter ended March 31, 2006 was $13,000.

As of March 31, 2006, total unrecognized compensation cost related to stock options granted under our various plans was $2.5 million. We expect that cost to be recognized over a weighted-average period of 1.7 years.

Summary of Restricted Stock Units

Restricted stock units were awarded for the first time in the first quarter of 2006 under our 1999 Equity Incentive Plan. A total of 145,000 restricted stock units were granted and remain unvested as of March 31, 2006. The fair value of these grants was calculated based upon the fair market value of our stock at the date of grant, less an estimate of pre-vesting forfeitures. The weighted-average grant-date fair value of restricted stock units awarded during the first quarter of fiscal 2006 was $5.05 As of March 31, 2006, there was $556,000 of total unrecognized compensation cost related to unvested restricted stock units granted, which is expected to be recognized over a weighted-average period of 2.2 years. No restricted stock units vested or were forfeited during Q1 2006.

Employee Stock Purchase Plan

As of March 31, 2006, we had issued 533,120 shares over the life of the ESPP. No shares were issued during the first quarters of fiscal 2006 and fiscal 2005. We currently have 166,880 shares in reserve for future issuance under the plan.

ESPP awards for offering periods prior to and after the adoption of SFAS No. 123R were valued using the Black-Scholes model using the following assumptions:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three months ended March 31,

 

 

 


 

 

 

2006

 

2005

 

 

 



 



 

Risk-free interest rate

 

 

 

3.4

%

 

 

 

1.6

%

 

Expected volatility

 

 

 

48.0

%

 

 

 

54.0

%

 

Expected life (in years)

 

 

 

1

 

 

 

 

1

 

 

Dividend yield

 

 

 

0.0

%

 

 

 

0.0

%

 

Disclosures Pertaining to All Share-Based Compensation Plans

Cash received under all share-based payment arrangements for the first quarter of fiscal 2006 and fiscal 2005 was $26,000 and $75,000, respectively. Because of our net operating losses and related valuation allowance, we did not realize any tax benefits for the tax deductions from share-based payment arrangements during the first quarters of fiscal 2006 and fiscal 2005.

3. Comprehensive Income (Loss)

We have no items of other comprehensive income (loss), and accordingly, the comprehensive income (loss) is equal to the net income (loss) for all periods presented.

4. Warranties; Indemnification

We generally provide a warranty that our 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, we have not incurred any material costs associated with these warranties and have no accrual for such items at March 31, 2006.

Page 11


Notes to Condensed Financial Statements

4. Warranties; Indemnification (continued)

From time to time, we enter into contracts that require us, upon the occurrence of certain contingencies, to indemnify parties against third party claims. These contingent obligations primarily relate to (i) claims against our customers for violation of third party intellectual property rights caused by our products; (ii) claims resulting from personal injury or property damage resulting from our activities or products; (iii) claims by our office lessor arising out of our use of the premises; and (iv) agreements with our officers and directors under which we may be required to indemnify such persons for liabilities arising out of their activities on behalf of ourselves. 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 our balance sheet as of March 31, 2006 or December 31, 2005.

5. Related Party Transaction

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

During the quarter ended March 31, 2006, we recorded $37,000in royalties receivable from PSC. For the comparable period in 2005, we recorded $12,000 in royalties receivable. Amounts received to date and any future receipts are being reported as other income as we do not consider these royalties to be part of our recurring operations.

6. Provision for Income Taxes

In the three months ending March 31, 2006, we recorded no income tax provision due to our loss. For the three months ended March 31, 2005 we recorded an income tax provision of $26,000. The tax provision for the three months ended March 31, 2005 principally consisted of federal and state taxes currently payable offset by the utilization of net operating losses resulting in an effective tax rate of approximately 2%. Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“SFAS 109”) provides for the recognition of deferred tax assets if realization of such assets is more likely than not. Based upon the weight of available evidence, which includes our historical operating performance and previously reported net losses, we continue to maintain a full valuation allowance against our remaining net deferred tax assets.

7. Commitments and Contingencies

On July 15, 2005, SkyTech, Inc. (“SkyTech”) filed a complaint against us in the District Court for the State of Minnesota, Fourth Judicial District, alleging claims of fraud, breach of contract, breach of duty of good faith and fair dealing, tortious interference, and indemnity. SkyTech alleged that it entered into an independent sales representative agreement (the “Agreement”) with us in October 2002 pursuant to which it has an exclusive right to market our products to the “After School” market. SkyTech further alleged that we prevented SkyTech’s performance of the Agreement and that we wrongly terminated the Agreement. SkyTech asserted that it was entitled to an unspecified amount of damages comprised of lost commissions and other damages, attorney’s fees, costs and punitive damages. In addition to the SkyTech claims, SkyLearn, L.L.C, and HEK, Inc., both of which claimed to be subcontractors of SkyTech, claimed that they suffered damages from our alleged actions with respect to SkyTech. In December 2005 the court granted our motion to dismiss the case and to compel arbitration. The Plaintiffs have filed an appeal of the ruling.

In October 2005 we initiated an arbitration proceeding before the American Arbitration Association in San Francisco, California. Our arbitration complaint alleges that SkyTech owes us for training charges that remain unpaid under the Agreement and seeks declaratory relief regarding SkyTech’s claims against us. SkyTech has asserted counterclaims against us in the arbitration, repeating the claims made in the Minnesota case and asserting damages of $10 million. This arbitration is on hold pending the outcome of the appeal in the Minnesota state court.

Page 12


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

This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements are not historical facts but rather are based on current expectations about our business and industry, as well as our beliefs and assumptions. Words such as “may,” “will,” “should,” “expects,” “intends,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “continue” and variations and negatives of these words and similar expressions are used to identify forward-looking statements. All forward-looking statements, including but not limited to those identified with asterisks (*) in this report, are not guarantees of future performance or events, and are subject to risks, uncertainties and other factors, many of which are beyond our control and some of which we may not even be presently aware. As a result, our future results and other future events or trends may differ materially from those anticipated in our forward-looking statements. Specific factors that might cause such a difference include, but are not limited to, the risks and uncertainties discussed in this Management’s Discussion and in the Risk Factors section of this Report. We also refer you to the risk factors that are or may be discussed from time to time in our public announcements and filings with the SEC, including our future Forms 8-K, 10-Q and 10-K. Readers are cautioned not to place undue reliance on forward-looking statements, which reflect our view only as of the date of this report. We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise after the date of this report.

Overview

We develop and distribute the Fast ForWord® family of reading intervention software. Our innovative products build learning capacity by applying advances in neuroscience to develop the fundamental cognitive skills required to read and learn. Extensive outcomes research by independent researchers, our founding scientists, and our company demonstrates that the Fast ForWord products help students attain rapid, lasting gains in the skills critical for reading. To facilitate the use of our products, we offer a variety of on-site and remote professional and technical services, as well as phone, email and web-based support. Our primary market is K-12 schools in the United States, to which we sell using a direct sales force. For the three months ended March 31, 2006, K-12 schools accounted for 93% of booked sales. By the end of March 2006, approximately 3,900 schools had purchased at least $10,000 of our Fast ForWord product licenses and services. During the three months ended March 31, 2006, approximately 50,000 individuals enrolled in one of our products. As of March 31, 2006 we had 183 full-time employees, compared to 166 at March 31, 2005.

Business Highlights

The K-12 education market is large and growing. According to the National Center for Education Statistics, there are 54 million K-12 students with the number growing to nearly 57 million in 2014. Eduventures, a strategic consulting firm in the education industry, has estimated that in 2003, K-12 schools spent $3.3 billion on supplemental content for all subject areas. Another market gauge, provided by the Education Market Report’s Complete K-12 Newsletter (July 2005), estimated the market for all educational software at approximately $800 million for the 2004-2005 school year. This represents growth of approximately 10% over 2003-2004, compared to declining or flat sales in the years from 2001 to 2004.

According to a recent survey by the National Conference of State Legislatures, state budget conditions continue to improve.* State budget overruns are declining, although states still report increasing spending demands for Medicaid and other health care programs, corrections, pensions, education and other priorities.*

Among the federal education programs, we believe that Title 1 and IDEA (special education) have been the most significant sources of funds for purchases of Fast ForWord licenses. The 2006 federal appropriations for these programs are at approximately the same level as in 2005. The current federal budget deficit and competing priorities, however, may impact the continuing availability of federal education funding.

The federal No Child Left Behind (NCLB) Act of 2001 established reading achievement, grade level proficiency, and accountability through assessment as important national priorities. NCLB also emphasizes the need to use proven practices and products grounded in scientifically based research to improve student performance. Our products align well with the emphases of NCLB, and we believe that this alignment assists us in marketing and selling our products.

Page 13


Company Highlights

For the three months ended March 31, 2006, our total booked sales increased by 44% over the same period in 2005. (Booked sales is a non-GAAP financial measure. For more explanation on booked sales, see Revenue below). These results exceeded our expectations for the quarter.

While booked sales growth in the first quarter was substantial compared to the comparable quarter in 2005, the first quarter historically is our smallest booked sales quarter. As we have discussed before, the characteristics of our public school market cause us to have a somewhat long and unpredictable sales cycle. During 2005, we saw educational decision makers grow more cautious in their decision-making, further lengthening our sales cycle. While the results from the first quarter of 2006 are encouraging, we do not expect to maintain this growth rate during the remainder of 2006.* Our target annual growth rate remains 20%-30%.*

For the three months ended March 31, 2006, we closed 18 transactions in excess of $100,000, compared to ten in the first quarter of 2005. One of our major goals is to increase the number of large booked sales, which we believe to be an important indicator of education industry acceptance and critical to achieving our targets. These large transactions frequently require school board approvals and their timing is often difficult to predict.

For the three months ended March 31, 2006, our revenue decreased 24% compared to the same period in 2005. Product revenue was down 32% compared to the same period in 2005. The main reasons for the change in product revenues are a one-time shift of product revenue from December 2004 to January 2005, and a decrease in the amount of revenue from prior period sales, partially offset by higher revenue from current quarter sales in the three months ended March 31, 2006 than in the same period in 2005. This is discussed in greater detail in Revenue below. Service and support revenue increased modestly. In 2005 we recognized more revenue than we had in booked sales, resulting in a decrease in deferred revenue. We expect this to reverse in 2006, with booked sales greater than revenues and deferred revenue growing.*

For the three months ended March 31, 2006, gross profit decreased due to lower product revenue (which has significantly higher gross margins than service and support revenue) and lower gross margin on services and support as we continue to invest in that organization. Operating expenses increased 10%, with half of that growth due to the expensing of equity compensation due to the adoption of SFAS No. 123R in the first quarter of 2006. For the three months ended March 31, 2006, equity compensation expense was $381,000. More detail on SFAS No. 123R is available in Note 2, Stock-Based Compensation. The remaining increase in operating expenses was due to increased commissions and compensation associated with a growing direct sales force and a 44% increase in booked sales over the same period in 2005.

We recorded a net loss for the three months ended March 31, 2006 compared to a net profit in the same period in 2005 due to significantly lower gross profit, driven by the decline in product revenue.

At March 31, 2006 and December 31, 2005, we had no outstanding debt.

Results of Operations

Revenues

 

 

 

 

 

 

 

 

 

 

Three months ended March 31,

 

 

 



(dollars in thousands)

 

2006

 

Change

 

2005

 












Products

 

$

5,348

 

-32

%

 

$

7,833

 

Service and support

 

 

2,483

 

3

%

 

 

2,412

 












Total revenues

 

$

7,831

 

-24

%

 

$

10,245

 












Product revenues, which comprise the bulk of our revenue, decreased significantly during the three months ended March 31, 2006, compared to the same period in 2005. There were three main factors that affected product revenues. First, $2.3 million of products sold in December 2004 were not recognized as revenue until delivered to the customer in January 2005. There was no corresponding shift of revenue out of December 2005 into January 2006. The second factor is recognition of revenue from prior period sales. Revenue from prior period sales (exclusive of the $2.3 million item above) was $2.9 million lower in the three months ended March 31, 2006 than in the same period in

Page 14


2005. These two decreases were partially offset by an increase in revenue recognized from current quarter sales, which was $2.8 million higher in the three months ended March 31, 2006 than during the same period in 2005. For the three months ended March 31, 2006, approximately $3.8 million of sales booked in that period was recognized as product revenue in the quarter of sale. This represents approximately 56% of total booked sales for the three months ended March 31, 2006. For the comparable period in 2005, approximately $1.1 million of sales were recognized into product revenue, representing approximately 22% of total sales. As a result of our December 2004 strategic pricing change, we now recognize most of our perpetual license revenue in the quarter of sale rather than over the related service period.

Our service and support revenue increased modestly during the three months ended March 31, 2006, compared to the same period in 2005 due to a higher number of schools on support and more services delivered, offset by a reduction in support prices for new customers.

Future revenue: As a result of our December 2004 strategic pricing change, during 2005 we recognized current booked sales into revenue substantially more quickly than we did in 2004. See Revenue Recognition below for more detail about our revenue recognition practices. At the same time, we continued to recognize deferred revenue from earlier years’ perpetual license sales into current revenue. This non-recurring impact from our transition to a different pricing structure resulted in 2005 revenue exceeding 2005 booked sales. During 2006, we expect booked sales to exceed revenue, resulting in deferred revenue growth.* We also expect revenue to decline in 2006, compared to 2005 revenue.* We expect that the positive impact on revenue of sales prior to the December 2004 pricing change will be minimal in 2006 and 2007.*

Booked sales and selling activity: Booked sales is a non-GAAP financial measure that management uses to evaluate current selling activity. We believe that booked sales is a useful metric for investors as well as management because it is the most direct measure of current demand for our products and services. Booked sales equals the total value (net of allowances) of software, services and support invoiced in the period. We record booked sales and deferred revenue when all of the requirements for revenue recognition have been met, other than the requirement that the revenue for software licenses and services has been earned. We use booked sales information for resource allocation, planning, compensation and other management purposes. We believe that revenue is the most comparable GAAP measure to booked sales. However, booked sales should not be considered in isolation from revenues, and is not intended to represent a substitute measure of revenues or any other performance measure calculated under GAAP.

The following reconciliation table sets forth our booked sales, revenues and change in deferred revenue for the three months ended March 31, 2006 and 2005.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three months ended March 31,

 

 

 

 



(dollars in thousands)

 

 

2006

 

 

Change

 

 

2005

 












Booked sales

 

$

6,784

 

 

 

44

%

 

$

4,727

 

Less revenue

 

 

7,831

 

 

 

(24

%)

 

 

10,245

 














Net increase/decrease in deferred revenue

(

$

1,047

)

 

 

 

 

(

$

5,518

)

 

 

 

 

 

 

 

 

 

 

 

 

 

Total deferred revenue beginning of period

 

$

17,003

 

 

 

(34

%)

 

$

25,784

 














Short-term deferred revenue end of period

 

$

10,944

 

 

 

(29

%)

 

$

15,311

 

Long-term deferred revenue end of period

 

$

5,012

 

 

 

1

%

 

$

4,955

 














Total deferred revenue end of period

 

$

15,956

 

 

 

(21

%)

 

$

20,266

 














Booked sales in the K-12 sector increased 48% to $6.3 million during the three months ended March 31, 2006, compared to $4.2 million in the same period in 2005. While this performance exceeded our long-term growth target of 20%-30%, the first quarter is generally our lowest booked sales quarter. While the results from the first quarter of 2006 are encouraging, we do not expect to maintain this growth rate during the remainder of 2006.* Our target annual booked sales growth rate remains 20%-30%. * As we have discussed before, characteristics of our public school market cause us to have a somewhat long and unpredictable sales cycle.

Booked sales to the K-12 sector for the three months ended March 31, 2006 were 92% of total booked sales, compared to 89% in the same period in 2005. Booked sales to non-school customers, primarily private practice clinicians, increased by $5,000, or 1%, for the three months ended March 31, 2006. We expect modest growth in

Page 15


booked sales to non-school customers during the remainder of 2006, as sales to correctional institutions and international customers are expected to grow.*

We believe large booked sales are an important indicator of mainstream education industry acceptance and an important factor in reaching our goal of increasing sales force productivity.* During the first quarter of 2006, we closed 18 sales that had a contract value in excess of $100,000 compared to ten during the same period in 2005. For the three months ended March 31, 2006, approximately 70% of our K-12 booked sales were realized from booked sales over $100,000. For the comparable period in 2005, these large booked sales accounted for approximately 51% of booked sales. Large booked sales include volume and negotiated discounts but the percentage discount applicable to any given transaction will vary and the relative percentage of large booked sales and smaller booked sales in a given quarter may fluctuate. Because we discount product license fees but do not discount service and support fees, product booked sales and revenue are disproportionately affected by discounting. We cannot predict the size and number of large transactions in the future.*

Although federal, state and local budget pressures make for an uncertain funding environment for our customers, we remain optimistic about our growth prospects in the K-12 market.* However, achieving our booked sales growth objectives will depend on increasing customer acceptance of our products, which requires us to continue to focus on improving our products’ ease of use, their fit with school requirements, and our connection with classroom teachers and administrators.* Our K-12 growth prospects are also influenced by factors outside our control, including the overall level, certainty and allocation of state, local and federal funding. In addition, the revenue recognized from our booked sales can be unpredictable. Our various license and service packages have substantially differing revenue recognition periods, and it is often difficult to predict which license package a customer will purchase, even when the amount and timing of a sale can be reasonably projected. See “Management’s Discussion and Analysis – Application of Critical Accounting Policies” for a discussion of our revenue recognition policy. In addition, the timing of a single large order or its implementation can significantly impact the level of booked sales and revenue at any given time. See “Risk Factors” for a further discussion of some of the factors that affect our sales and revenue.

Gross Profit and Cost of Revenues

 

 

Three months ended March 31,

 

 


 

 

 

2006

 

 

2005

 

 

 






 

 






(dollars in thousands)

 

$ Profit

   Margin %

 

$ Profit

   Margin %















Gross profit on products

 

$

5,028

 

94

%

 

$

7,400

 

 

94%

 

Gross profit on services and support

 

 

634

 

26

%

 

 

1,052

 

 

44%

 















Total gross profit

 

$

5,662

 

72

%

 

$

8,452

 

 

82%

 















The overall gross profit margin decreased significantly due to a revenue mix shift. High margin product revenues made up 68% of total revenues in the three months ended March 31, 2006, compared to 76% in the same period in 2005. Product margins remained unchanged at 94% during the two periods. Higher expenses in service and support more than offset modest revenue growth. This expense growth in service and support is due to additional staff and their associated expenses. Expenses that increased for services and support during the three months ended March 31, 2006 versus the same period in 2005 include compensation expense ($146,000), customer conferences ($138,000), travel and entertainment ($96,000), consulting ($54,000) and equity compensation expense ($40,000).

Operating Expenses

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three months ended March 31,

 

 

 



(dollars in thousands)

 

 

2006

 

 

Change

 

 

2005

 












Sales and marketing

 

$

5,379

 

 

 

13

%

 

$

4,763

 

Research and development

 

 

1,022

 

 

 

10

%

 

 

933

 

General and administrative

 

 

1,567

 

 

 

2

%

 

 

1,537

 














Total operating expenses

 

$

7,968

 

 

 

10

%

 

$

7,233

 














Sales and Marketing Expenses: For the three months ended March 31, 2006, our sales and marketing expenses increased 13% or approximately $616,000. This increase is due to multiple factors, including increased staffing ($229,000), equity compensation expense ($138,000), travel expenses ($101,000) and commissions ($100,000). At March 31, 2006, we had 39 quota-bearing field sales personnel compared to 36 at March 31, 2005.

Page 16


Research and Development Expenses: Research and development expenses increased in the three months ended March 31, 2006, compared to the same period in 2005 primarily due to equity compensation expense of $62,000. Research and development expenses principally consist of compensation paid to employees and consultants engaged in research and product development activities and product testing, together with software and equipment costs.

General and Administrative Expenses: General and administrative expenses increased modestly in the three months ended March 31, 2006, compared to the same period in 2005, as increases in equity compensation expense of ($141,000), employee compensation ($100,000) and legal ($61,000) were largely offset by spending reductions primarily in consulting ($124,000), depreciation ($53,000) and audit fees ($53,000).

Adoption of SFAS No. 123R

We have four active share-based compensation plans for the issuance of stock options, restricted stock units and an employee stock purchase plan (ESPP). Prior to fiscal 2006, we accounted for these plans under the recognition and measurement provisions of APB Opinion No. (APB) 25, Accounting for Stock Issued to Employees, and related guidance, as permitted by SFAS 123, Accounting for Stock-Based Compensation. Accordingly, we did not recognize any significant amounts of share-based employee compensation expense in our statements of operations prior to fiscal 2006; instead, we provided footnote disclosure of our pro forma results of operations as if we had recognized compensation expense in accordance with SFAS 123.

Beginning in the first quarter of fiscal 2006, we adopted the fair value recognition provisions of SFAS No. 123R, Share-Based Payment, using the modified-prospective transition method. Under that transition method, compensation cost recognized in the first quarter of fiscal 2006 includes the following: (a) compensation cost related to any share-based payments granted through, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, and (b) compensation cost for any share-based payments granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123R.

As a result of adopting SFAS No. 123R, we recognized share-based compensation expense of $381,000 during the first quarter of fiscal 2006, comprised of restricted stock units, issued for the first time, and stock option expense from grants in previous periods. No stock options were issued in the first quarter of fiscal year 2006. The total share based expense primarily affected our reported sales and marketing and general and administrative departments.

We calculated the restricted stock unit expense based upon the fair market value of our stock at the date of grant. As of March 31, 2006, total unrecognized compensation expense related to restricted stock units granted during the first quarter of fiscal year 2006 was $556,000, which we expect to be recognized over a weighted-average period of 2.2 years.

We calculated the option-related expense based on the fair values of the awards as estimated using the Black-Scholes option valuation model. Use of this model requires us to make assumptions about expected future volatility of our stock price and the expected term of the options that we grant. Calculating stock option expense under SFAS No. 123R also requires us to make assumptions about expected future forfeiture rates for our option awards. As of March 31, 2006, total unrecognized compensation expense related to unvested stock options already granted under our various plans was $2.5 million, which we expect to be recognized over a weighted-average period of 1.7 years.

Other Income from Related Party

In September 2003, we signed an agreement with Posit Science Corporation (“PSC”), transferring technology to PSC for use in the health field. During the three months ended March 31, 2006, we recorded $37,000 in royalties receivable from PSC. For the comparable period in 2005, we recorded $12,000 in royalties receivable. Amounts received to date and any future receipts are being reported as other income as we do not consider these royalties to be part of our recurring operations.

Page 17


Interest Income, net

 

 

 

 

 

 

 

 

 

 

 

 

 

Three months ended March 31,

 

 




(dollars in thousands)

 

2006

 

Change

 

2005

 









Interest income, net

 

$95

 

11%

 

$85

 









In the three month period ended March 31, 2006, we generated interest income from our cash balances. During 2005, we also earned interest from our cash balances plus $38,000 in interest income on our loans to current and former officers. In 2006 there was no further interest income from loans to former officers as those loans have been fully repaid. The primary reason for the increase in interest income was the increase in interest rates on our cash balances.

Provision for Income Taxes

In the three months ending March 31, 2006, we recorded no income tax provision due to our loss. For the three months ended March 31, 2005 we recorded an income tax provision of $26,000. Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“SFAS 109”) provides for the recognition of deferred tax assets if realization of such assets is more likely than not. Based upon the weight of available evidence, which includes our historical operating performance and previously reported net losses, at March 31, 2006 we continue to maintain a full valuation allowance against our remaining net deferred tax assets.

Liquidity and Capital Resources

Our cash, cash equivalents and short term investments were $8.2 million at March 31, 2006, compared to $12.1 million at December 31, 2005. We expect that our cash flow from operations and our current cash balances will be the primary source of liquidity and will be sufficient to provide the necessary funds for our operations and capital expenditures during at least the next 12 months.* Accomplishing this, however, will require us to meet specific booked sales targets in the K-12 market. We cannot assure you that we will meet our targets with respect to booked sales, revenues, expenses or operating results.

If we are unable to achieve sufficient cash flow from operations, we may seek other sources of debt or equity financing, or may be required to reduce expenses.* Reducing our expenses could adversely affect operations by reducing the resources available for sales, marketing, research or product development.* We cannot assure you that we will be able to secure additional debt or equity financing on acceptable terms, if at all.

Historically, our first quarter is our lowest booked sales quarter, reflecting school purchasing cycles and a trend in our industry.* Therefore, we may have negative cash flow in some quarters, particularly the first quarter, and may borrow funds from time to time.* We generally use cash in operations during the first quarter and this trend continued in 2006.

Net cash used in operating activities for the three months ended March 2006 was $3.9 million versus cash used of $3.5 million during the same period in 2005. This difference was the result of higher spending, primarily due to increased headcount, additional marketing efforts and higher travel expenses, partially offset by lower commission and bonus payments, reflecting the lower booked sales difference between 2005 compared to 2004.

Net cash generated by investing activities for the three months ended March 31, 2006 was $3.1 million, due to the maturity of $3.0 million of short term investments. We also received the final payment on our outstanding officer loans during the three months ended March 31, 2006 of $213,000. Our capital expenditures of $187,000 in the three months ended March 31, 2006, compared to $87,000 for the same period in 2005. Capital spending primarily consists of purchases of computer hardware and software. We expect that our capital spending will be higher in 2006 than in 2005 on a full year basis, as we expect to make additional systems investments in 2006.*

For the three months ended March 31, 2006 and March 31, 2005 we had no borrowings.

Page 18


Off-Balance Sheet Arrangements

We have no off-balance sheet arrangements.

Contractual Obligations and Commitments

We have a non-cancelable lease agreement for our corporate office facilities. The minimum lease payment is approximately $78,000 per month through 2008. After 2008 the base lease payment increases at a compound annual rate of approximately 5%. The lease terminates in December 2013.

The following table summarizes our obligations at March 31, 2006 and the effects such obligations are expected to have on our liquidity and cash flow in future periods.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(dollars in thousands)

 

Total

 

Less than
1 year

 

2 - 3 years

 

4 - 5 years

 

Thereafter

 













Non-cancelable operating lease

 

$

7,991

 

$

940

 

$

1,891

 

$

2,039

 

$

3,121

 

Minimum royalty payments

 

 

1,313

 

 

150

 

 

300

 

 

300

 

 

563

 


















Total

 

$

9,304

 

$

1,090

 

$

2,191

 

$

2,339

 

$

3,684

 


















 

 

Non-cancelable operating lease expires on 12/31/2013. Minimum royalty payments expire in 2014.

 

Our purchase order commitments at March 31, 2006 are not material.

Loans to Current and Former Officers

In March 2001 we made full recourse loans to certain of our officers, in amounts totaling $3.1 million. The notes were full recourse loans secured by shares of our Common Stock owned by our current and former officers. The loans bore interest at 4.94%. Principal and interest for all notes were due December 31, 2005. All amounts were paid on or prior to the maturity date, except $297,000, which was paid during the three months ended March 31, 2006 with $213,000 in cash and $84,000 in surrendered stock. No further amounts are due.

Application of Critical Accounting Policies

Our financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). These accounting principles require us to make certain estimates, assumptions and judgments. We believe that the estimates, assumptions and judgments upon which we rely are reasonable based upon information available to us at the time. The estimates, assumptions and judgments that we make can 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. To the extent there are material differences between these estimates and actual results, our financial statements would be affected.

We believe that the estimates, assumptions and judgments pertaining to revenue recognition, allowance for doubtful accounts, software development costs and long-lived assets are the most critical assumptions to understand in order to evaluate our reported financial results. A detailed discussion of our use of estimates, assumptions and judgments as they relate to these polices is presented below. We have discussed the application of these critical accounting policies with the Audit Committee of the Board of Directors.

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 exists; 2) delivery of the product has occurred; 3) a fixed or determinable fee; and 4) the probability that the fee will be collected. The application of SOP 97-2 requires us to exercise significant judgment related to our specific transactions and transaction types.

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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). We allocate revenue to each element of a transaction based upon its fair value as determined in reliance on “vendor specific objective evidence” (“VSOE”), if VSOE exists for each element. As we do not have VSOE for software licenses, we normally recognize revenue using the residual method on arrangements with multiple elements that include software licenses, whereby the difference between the total arrangement fee and the total fair value of the undelivered elements (generally services and support) is recognized as revenue relating to software licenses. 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. We are required to exercise judgment in determining whether VSOE exists for each undelivered element based on whether our pricing for these elements is sufficiently consistent.

The value of software licenses, services and support invoiced during a particular period is recorded as deferred revenue until recognized. All revenue from transactions that include new products that have not yet been delivered is deferred until the delivery of all products. Deferred revenue is recognized as revenue as discussed below.

Product revenue

Product revenue is primarily derived from the licensing of software and 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.

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.

Allowance for Doubtful Accounts

We maintain an allowance for doubtful accounts for estimated losses due to the inability of customers to make payments. These estimates are based on historical experience. In 2005 our bad debt experience was less than 1% of revenue. To the extent experience requires it, we may in the future adjust this allowance.* Cancellations and refunds are allowed in limited circumstances, and such amounts have not been significant.

Software Development Costs

We capitalize software development cost in accordance with Financial Accounting Standards Board (FASB) Statement No. 86 “Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed,” under which software development costs incurred subsequent to the establishment of technological feasibility are capitalized and amortized over the estimated life of the related product.

Prior to the establishment of technological feasibility we expense all software development cost associated with a product. Technological feasibility is deemed established upon completion of a working version. We estimate the useful life of our developed products to be 3 years.

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On an ongoing basis, we evaluate the net realizable value of the capitalized software development cost by estimating the future revenue to be generated from the product and compare this estimate to the unamortized cost of the product. At March 31, 2006 future revenues from sale of products for which development costs remain on the balance sheet are anticipated to exceed the $65,000 of unamortized development costs.* The amortization of capitalized software should be complete in the quarter ending June 30, 2006, providing no additional capitalization occurs.* No software development costs were capitalized in the three months ended March 31, 2006 or 2005.

Impairment of Long-Lived Assets

We regularly review the carrying value of capitalized software development costs and property and equipment. We continually make estimates regarding the probability of 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.

Stock-Based Compensation

Under the fair value recognition provisions of SFAS No. 123R, we used the Black-Scholes option valuation model to estimate stock-based compensation expense at the grant date based on the fair value of the award and we will recognize the expense ratably over the requisite service period of the award. Determining the appropriate fair value model and assumptions used in calculating the fair value of stock-based awards requires judgment, including estimating stock price volatility, forfeiture rates and expected life.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Interest Rate Risk

Our exposure to market risk for changes in interest rates relates primarily to the rate of interest we will pay on our revolving credit facility with Comerica Bank. Interest rates on loans extended under that facility are at a floating prime rate, or a fixed rate of LIBOR plus 2.5%. A hypothetical increase or decrease in market interest rates by 10% from the market interest rates at March 31, 2006 would not have a material affect on our results of operations.

Item 4. Controls and Procedures

Evaluation of Disclosure 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 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.

As required under Rule 13a-15(b) of the Exchange Act, our 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, and concluded that our disclosure controls and procedures were effective as of March 31, 2006.

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. Our 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.

Changes in Internal Controls over Financial Reporting

There were no changes in our internal control over financial reporting during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

On July 15, 2005, SkyTech, Inc. (“SkyTech”) filed a complaint against us in the District Court for the State of Minnesota, Fourth Judicial District, alleging claims of fraud, breach of contract, breach of duty of good faith and fair dealing, tortious interference, and indemnity. SkyTech alleged that it entered into an independent sales representative agreement (the “Agreement”) with us in October 2002 pursuant to which it has an exclusive right to market our products to the “After School” market. SkyTech further alleged that we prevented SkyTech’s performance of the Agreement and that we wrongly terminated the Agreement. SkyTech asserted that it was entitled to an unspecified amount of damages comprised of lost commissions and other damages, attorney’s fees, costs and punitive damages. In addition to the SkyTech claims, SkyLearn, L.L.C and HEK, Inc., both of which claimed to be subcontractors of SkyTech, claimed that they suffered damages from our alleged actions with respect to SkyTech. In December 2005, the court granted our motion to dismiss the case and to compel arbitration. The Plaintiffs have filed an appeal of the ruling.

In October 2005 we initiated an arbitration proceeding before the American Arbitration Association in San Francisco, California. Our arbitration complaint alleges that SkyTech owes us for training charges that remain unpaid under the Agreement and seeks declaratory relief regarding SkyTech’s claims against us. SkyTech has asserted counterclaims against us in the arbitration, repeating the claims made in the Minnesota case and asserting damages of $10 million. This arbitration is on hold pending the outcome of the appeal in the Minnesota state court.

Item 1A. Risk Factors

The following factors as well as other information contained in this report should be considered in making any investment decision related to our common stock. If any of the following risks actually occurs, our business, financial condition and results of operations could be materially and adversely affected and the trading price of our common stock could decline.

To grow our business, we need to increase acceptance of our products among K-12 education purchasers. Failure to do so would materially and adversely impact our revenue, profitability and growth prospects.

We believe that to date most educators who have used Fast ForWord products are “early adopters.” Early adopters make up a relatively small proportion of the K-12 market, so in order to grow our revenue and profit, we need to increase our booked sales beyond early adopters to more conservative customers. We believe that our ability to grow acceptance of our products in the conservative K-12 education market will depend largely on the critical factors discussed below.

Our Fast ForWord products use an approach that differs from the approaches that schools have traditionally used to address reading problems. In particular, our products work because they increase learning capacity, are based on neuroscience research and focus on the development of cognitive skills. All of these concepts may be unfamiliar to educators. K-12 educational practices are slow to change, and it can be difficult to convince educators of the value of a substantially different approach.

In order to obtain the best student results from using our product, schools must follow a recommended protocol for Fast ForWord use, which requires a substantial amount of time out of a limited and already crowded school day. Our recommendation that schools follow a prescribed protocol in using our products may limit the number of schools willing to purchase from us. In addition, if our products are not used in accordance with the protocol, they may not produce the expected student results, which may lead to customer dissatisfaction and decreased booked sales.

Our products are generally implemented in a computer lab with a lab coach or teacher rather than in the classroom with the students’ regular classroom teachers. To better reach mainstream customers, encourage additional sales from existing customers and improve student achievement results, we need to better engage classroom teachers in the products’ implementation, in an effective and efficient manner.

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We encourage our customers to purchase significant levels of field service because we believe that these services enable more effective product use and lead to stronger student achievement gains. If we are unable to continue to convince customers to purchase these levels of service, customers may experience more difficulty with their implementations.

If we are unable to convince our market of the value of our significantly different approach and otherwise overcome the challenges identified above, our sales and growth prospects could be materially and adversely impacted and our profitability could decline.

It is difficult to accurately forecast our future financial results, and we believe that in 2006 our quarterly revenue has become more difficult to predict. This may cause us to fail to achieve the financial performance anticipated by investors and financial analysts, which could cause the price of our stock to decline.

Our booked sales, revenues and net income or loss are difficult to predict and may fluctuate substantially from quarter to quarter as a result of many factors, including those discussed below.

A significant proportion of our customers’ purchases are made within the last two weeks of each quarter. We therefore have limited visibility on actual booked sales for the quarter until the end of the quarter. If a customer unexpectedly postpones or cancels an expected purchase due to changes in the customer’s objectives, priorities, budget or personnel, we may experience an unexpected booked sales shortfall that cannot be made up in the quarter.

The timing of the recognition of revenue from our booked sales can also be unpredictable. Our various license and service packages have substantially differing revenue recognition periods, and it may be difficult to predict which license package a customer will purchase, even when the amount and timing of a sale can be projected.

Since our December 2004 pricing change, we recognize revenue from most of our perpetual license sales at the time of sale. Before that change, perpetual license revenue was recognized over the related service period. Because of this transition, in 2005 we recognized substantial revenue from perpetual licenses booked in 2003 and 2004, as well as perpetual license sales in 2005. In 2006, we expect that much more of our perpetual license revenue in each quarter will be derived from sales in that quarter.* Because our booked sales are difficult to predict, our quarterly perpetual license revenue has therefore become more unpredictable.

In addition, our sales strategy emphasizes large, district-level, multi-site transactions. The receipt or implementation of a single large order, or conversely its loss or delay, can significantly impact the level of sales booked and revenue recognized in a given quarter.

Our expense levels are based on our expectations of future booked sales and are primarily fixed in the short term. We may not be able to adjust spending in a timely manner to compensate for any unexpected booked sales shortfall, which could cause our net income to fluctuate unexpectedly.

Failure to achieve the financial results expected by investors and financial analysts in a given quarter could cause an immediate and significant decline in the trading price of our common stock.

Our current liquidity resources may not be sufficient to meet our needs.

We believe that cash flow from operations will be our primary source of funding for our operations during 2006 and the next several years.* In 2003 and 2004 we generated $3.9 and $6.3 million respectively in cash from operating activities. In 2005, we used $2.1 million in cash in our operating activities, reflecting the decline in our booked sales and higher expenses to support our growth goals. We expect to again generate positive cash flow from operations in 2006.* This will require us to achieve certain levels of booked sales and expenses.

In addition, we have a line of credit with Comerica Bank totaling $5.0 million, which expires June 2, 2007. At March 31, 2006 no borrowings were outstanding and we were in compliance with the covenants of that line.

If we are unable to achieve sufficient levels of cash flow from operations, or are unable to obtain waivers or amendments from Comerica in the event we do not comply with our covenants, we would be required either to obtain debt or equity financing from other sources, or to reduce expenses. Reducing our expenses could adversely affect our

Page 23


operations by reducing the resources available for sales, marketing, research or development efforts. We cannot assure you that we will be able to secure additional debt or equity financing on acceptable terms, if at all.

Our sales cycle tends to be long and somewhat unpredictable, which may result in delayed or lost revenue, which could materially and adversely impact our revenue and net income.

Like other companies in the instructional market, our booked sales to K-12 schools are affected by school purchasing cycles and procedures, which can be quite bureaucratic. The cost of some of our K-12 license packages requires multiple levels of approval in a political environment, which results in a time-consuming sales cycle that can be difficult to predict. When a district decides to finance its license purchase, the time required to obtain necessary approvals can be extended even further. In addition, booked sales to schools are subject to budgeting constraints, which may require schools to find available discretionary funds, obtain grants or wait until subsequent budget cycles. As a result, our sales cycle generally takes several months, and in some cases, can take a year or longer. Therefore, we may devote significant time and energy to a particular customer sale over the course of many months, and then not make the sale when expected or at all. This can result in lower revenue and lost opportunities that can materially and adversely impact our revenue and net income.

Throughout 2005, we saw educational decision makers grow more cautious in their decision-making, further lengthening our sales cycle.

The restatement of our financial statements has increased the possibility of legal or administrative proceedings against us.

In December 2004, based on our review of a major contract that we booked in June 2004, our management and the Audit Committee of our Board of Directors concluded that we should change our revenue recognition method for most of our K-12 school contracts. This change in our revenue recognition method reflected a correction in our application of AICPA Statement of Position 97-2, Software Revenue Recognition (as amended by Statement of Position 98-9) to most of our historical K-12 school contracts. As a result, we restated our financial statements for the period from 2000 through June 30, 2004, as described in more detail in our Report on Form 10-K/A for the year ended December 31, 2003, our Reports on Form 10-Q/A for the quarters ended March 31, 2004 and June 30, 2004 and our Report on Form 10-Q for the quarter ended September 30, 2004, all filed February 15, 2005.

In May 2005 our management determined that a portion of 2004 deferred revenue had been misclassified as long-term deferred revenue when it should have been classified as current deferred revenue. As a result, we restated our balance sheet as of December 31, 2004 in our Report on Form 10-K/A for the year ended December 31, 2004, filed on May 26, 2005.

As a result of these events, we have become subject to the following risks:

 

 

 

 

We have incurred substantial unanticipated costs for accounting and legal fees.

 

 

 

 

There is a risk that our investors may bring a class action lawsuit against us and our directors and officers based on the restatement of our historical financial statements. If such actions were to be brought, it is likely that we would incur substantial defense costs regardless of their outcome. Likewise, such actions might cause a diversion of our management’s time and attention. If such actions were brought and we did not prevail, we could be required to pay substantial damages or settlement costs.

 

 

 

 

There is a risk that the Securities and Exchange Commission may undertake an investigation of our company in light of the restatement of our historical financial statements. If any such investigation were commenced, it would likely divert more of our management’s time and attention and cause us to incur substantial costs. Such investigations could also lead to fines or injunctions or orders with respect to future activities.

In addition, the restatement reflected a material weakness in our internal control over financial reporting and disclosure controls and procedures. To address this material weakness, we hired additional accounting staff and implemented changes in our processes, procedures and controls relating to revenue and deferred revenue. Although our management has concluded and the Audit Committee has concurred that, at December 31, 2005, we no longer had a material weakness in our internal control over financial reporting, we cannot assure you that we will not detect

Page 24


additional material weaknesses in our internal control over financial reporting in the future, further compounding the risks identified above.

We may be unable to continue to be profitable.

We started operations in February 1996 and through 2002 incurred significant operating losses. We first became profitable in 2003, incurred a net loss in 2004 and were again profitable in 2005. We expect that in 2006 we will record a net loss,* partially because of the implementation of SFAS No. 123R, which requires us to record compensation expense for employee stock awards. At March 31, 2006, we had an accumulated deficit of approximately $80.3 million from inception.

Our strategic and operating goals include increasing our booked sales and cash flow. Our ability to achieve increased booked sales and cash flow depends on many factors, including but not limited to market acceptance of our products, availability of funding, customers’ prior experience with our products, and general economic conditions, some of which are outside of our control. To meet our booked sales targets, we will need to incur substantial expenditures. We cannot assure you that we will meet our targets with respect to booked sales, revenues or operating results.

We rely on studies of student performance results to demonstrate the effectiveness of our products. If the validity of these studies or the conclusions that we draw from them are challenged, our reputation could be harmed and our business prospects and financial results could be materially and adversely affected.

We rely heavily on statistical studies of student results on assessments to demonstrate that our Fast ForWord products lead to improved student achievement. Reliance on these studies to support our claims about the effectiveness of our products involves risks, including the following:

 

 

 

 

The results of studies depend on schools’ appropriately implementing the products and adhering to the product protocol. If a school does not do so, the study may not show that our products produce substantial student improvements.

 

 

 

 

Some studies on which we rely may be challenged because the studies use a limited sample size, lack a randomly selected control group, include assistance or participation from the Company or its scientists, or have other design characteristics that are not optimal. These challenges may assert that these studies are not sufficiently rigorous or free from bias, and may lead to criticism of the validity of the studies and the conclusions that we draw from them.

 

 

 

 

Schools studying the effectiveness of our products use the product with different types of students and use different assessments, sometimes making it difficult to aggregate or compare results.

Our sales and marketing efforts, as well as our reputation, could be adversely impacted if the studies upon which we rely to demonstrate the effectiveness of our products, or the conclusions we draw from those studies, are seen to be insufficient. The recent federal NCLB legislation has placed an increasing emphasis on the need for scientifically-based research. To the extent that scientifically-based research becomes more important to the education market, challenges to the research that we use in marketing our products could become more potentially harmful to us.

Claims relating to data collection from our user base may subject us to liabilities and additional expense.

Schools and clinicians that use our products frequently use students’ names to register them in our products and enter into our database academic, diagnostic and/or demographic information about the students. In addition, the results of student use of our products are uploaded to our database. We have designed our system to safeguard this personally-identifiable information, but the protection of such information is an area of increasing public concern and significant government regulation, including but not limited to the Children’s Online Privacy Protection Act. If our privacy protection measures prove to be ineffective, we could be subject to liability claims for unauthorized access to or misuses of personally-identifiable information stored in our database. We may also face additional expenses to analyze and comply with increasing regulation in this area.

Page 25


We may experience difficulties in launching new products efficiently, without significant technical issues, and on schedule. This could materially slow booked sales or decrease profitability.

We launched three new products in 2005 and we expect to launch additional products in 2006 and future years.* Unexpected challenges could make these development projects longer or more expensive than planned. In addition, new technology products usually contain bugs that are not discovered in the testing process, and tend to be more challenging to implement when they are first introduced, especially in the diverse and challenging K-12 technology environment. Any significant defect or deficiency in our products could cause customers to cancel or delay orders, cause us to incur significant expenses remedying the problem, and harm our reputation.

Booked sales of our products depend on the availability of government funding for public school reading intervention purchases, which is variable and outside the control of both us and our direct customers. If such funding becomes less available, our public school customers may be unable to purchase our products and services on a scale or at prices that we anticipate, which would materially and adversely impact our revenue and profitability.

US public schools are funded primarily through state and local tax revenues, which are devoted primarily to school building costs, teacher salaries and general operating expenses. Public schools also receive funding from the federal government through a variety of federal programs, many of which target children who are poor and/or struggling academically. Federal funds typically are restricted to specified uses.

We believe that the funding for a substantial portion of our K-12 booked sales comes from federal funding, in particular special education and Title 1 funding. The current federal budget deficit and competing federal priorities may impact the availability of federal education funding. A cutback in federal education funding could slow our booked sales.

State and local school funding can be significantly impacted by fluctuations in tax revenues due to changing economic conditions. We expect that future levels of state and local school spending will continue to be significantly affected by the general economic conditions and outlook. A downturn in the economy might slow our booked sales. Increased energy costs for schools may also affect the level of resources available for purchasing our products.

We compete for sales with companies that have longer histories and greater resources than we do. We may not be able to compete effectively in the education market.

The market in which we operate is very competitive. While our products are highly differentiated by their neuroscience basis and their focus on the development of cognitive skills, we nevertheless compete vigorously for the funding available to schools. We compete not only against other software-based reading intervention products but also against print and service-based offerings from other companies and against traditional methods of teaching language and reading. Many of the companies providing these competitive offerings are much larger than Scientific Learning, are more established in the school market than we are, offer a broader range of products to schools, and have greater financial, technical, marketing and distribution resources than we do. Encouraged by the No Child Left Behind Act, new competitors may enter our market segment and offer actual or claimed results similar to those achieved by our products. In addition, although traditional approaches to language and reading are fundamentally different from our approach, the traditional methods are more widely known and accepted and, therefore, represent significant competition for available funds.

We are not yet required to comply with Sarbanes-Oxley Section 404. We are presently engaged in a process of evaluating and documenting our internal control over financial reporting with the goal of achieving compliance no later than the end of 2007. The process is very costly and requires significant internal resources. If we are unable to comply with Section 404 when we are required to do so or are unable to conclude that our internal control over financial reporting is effective, such non compliance or ineffective controls could have a materially adverse effect on us.

Under Sarbanes-Oxley Section 404, as implemented by the SEC and PCAOB, we will be required to provide a management report and auditors’ attestation and report on our internal control over financial reporting. We have not previously been subject to this requirement. Under current rules, our deadline for compliance will be December 31, 2007, but it could be accelerated to December 31, 2006 if we become an “accelerated filer” under the US securities

Page 26


laws as of December 31, 2006. We will not know whether we will become an “accelerated filer” as of December 31, 2006 until June 30, 2006.

Historically, we have understood the importance of internal control over financial reporting, and on an ongoing basis, we evaluate our controls, assess whether we should improve them and, when appropriate, implement improvements. In connection with our restatements in 2005, we concluded that we had a material weakness in our internal controls relating to revenue and deferred revenue. To address this material weakness, we hired additional accounting staff and we implemented changes in our processes, procedures and controls relating to revenue and deferred revenue. In connection with the audit of our financial statements for the year ended December 31, 2005, management concluded and the Audit Committee concurred that, at December 31, 2005, we no longer had a material weakness in our internal control over financial reporting. We cannot assure you that, in the course of implementing our processes to achieve compliance with Section 404, we will not detect additional material weaknesses in our internal control over financial reporting.

If we lose key personnel or are unable to hire additional qualified personnel as necessary, we may not be able to achieve our business goals, which could materially and adversely affect our financial results and share price.

We depend on the performance of Robert Bowen, our Chairman and Chief Executive Officer, and on other senior management, sales, marketing, development, research, educational, finance and other administrative personnel with extensive experience in our industry and with our Company. The loss of key personnel could harm our ability to execute our business strategy, which could adversely affect our financial results and share price. In addition, we believe that our future success will depend in large part on our continued ability to identify, hire, retain and motivate highly skilled employees who are in great demand. We cannot assure you that we will be able to do so.

If we are unable to adequately protect our intellectual property rights or if we infringe on the rights of others, we could become subject to significant liabilities, need to seek licenses or lose our rights to sell our products.

Our ability to compete effectively depends in part on whether we are able to maintain the proprietary aspects of our technology and to operate without infringing on the proprietary rights of others. It is possible that our issued patents will not offer sufficient protection against competitors with similar technology, that our trademarks will be challenged or infringed by competitors, or that our pending patent applications will not result in the issuance of patents. In addition, we could become party to patent or trademark infringement claims, litigation or interference proceedings. These proceedings could result from claims that we are violating the rights of others or may be necessary to enforce our own rights. Any such proceedings would result in substantial expense and significant diversion of management effort. An adverse determination in such proceedings could subject us to significant liabilities or require us to seek licenses from third parties, which may not be available on commercially reasonable terms or at all.

Our most important products are based on licensed inventions owned by two universities. If we were to lose our rights under this license, it would materially harm our business. The licensor may terminate the license if we fail to perform our obligations and do not timely cure the violation. We believe that we are currently in compliance with the license in all material respects.

Our directors and executive officers and their affiliates effectively control the voting power of our company.

At December 31, 2005, Warburg, Pincus Ventures, our largest shareholder, owned approximately 46%of the Company’s outstanding stock and, in the aggregate, our directors and executive officers and their affiliates held more than 60% of the outstanding stock. As a result, these stockholders are able to exercise significant influence over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, and may have interests that diverge from those of other stockholders. This concentration of ownership may also delay, prevent or deter a change in control of our company.

Our common stock is thinly traded and its price is volatile.

Our common stock presently trades on the Nasdaq National Market, and our trading volume is low. For example, during 2005, our average daily trading volume was approximately 15,111 shares. The market price of our common

Page 27


stock has been highly volatile since our July 1999 initial public offering and could continue to be subject to wide fluctuations.

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Item 6. Exhibits and Reports on Form 8-K

          (a) Exhibits

 

 

 

 

 

 

Exhibit No.

 

Description of Document

 


 


 

3.1 (1)

 

Restated Certificate of Incorporation.

 

3.2 (2)

 

Amended and Restated Bylaws.

 

10.1(3)*

 

1999 Equity Incentive Plan, as amended.

 

10.2(3)*

 

Forms of Restricted Stock Unit Grant Notice and Restricted Stock Unit Agreement under the Incentive Plan.

 

10.3(3)*

 

Form of 1999 Employee Stock Purchase Plan Offering under the Employee Stock Purchase Plan.

 

10.4(3)*

 

2006 Management Incentive Plan.

 

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).


 

 

(1)

Incorporated by reference to Exhibit 3.3 previously filed with the Company’s Registration Statement on Form S-1 (SEC File No. 333-77133).

 

 

(2)

Incorporated by reference to Exhibit 3.4 previously filed with the Company’s Form 10-Q for the quarter ended September 30, 2003 (SEC File No. 000-24547).

 

 

(3)

Incorporated by reference to exhibits previously filed with the Company’s Form 10-K filed on March 14, 2006.

Page 29


SIGNATURE

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

Dated: May 11, 2006

 

 

 

 

SCIENTIFIC LEARNING CORPORATION

 

(Registrant)

 

 

 

/s/ Jane A. Freeman

 


 

 

Jane A. Freeman

 

Chief Financial Officer

 

(Authorized Officer and Principal Financial and

 

Accounting Officer)

Page 30


Index to Exhibits

 

 

 

 

Exhibit No.

 

Description of Document


 


3.1 (1)

 

Restated Certificate of Incorporation.

3.2 (2)

 

Amended and Restated Bylaws.

10.1(3)*

 

1999 Equity Incentive Plan, as amended.

10.2(3)*

 

Forms of Restricted Stock Unit Grant Notice and Restricted Stock Unit Agreement under the Incentive Plan.

10.3(3)*

 

Form of 1999 Employee Stock Purchase Plan Offering under the Employee Stock Purchase Plan.

10.4(3)*

 

2006 Management Incentive Plan.

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).


 

 

 

(1)

 

Incorporated by reference to Exhibit 3.3 previously filed with the Company’s Registration Statement on Form S-1.

 

 

 

(2)

 

Incorporated by reference to Exhibit 3.4 previously filed with the Company’s Form 10-Q for the quarter ended September 30, 2003.

 

 

 

(3)

 

Incorporated by reference to exhibits previously filed with the Company’s Form 10-K filed on March 14, 2006.



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