ITEM 1.
BUSINESS
Overview
We create educational software that accelerates learning by improving the processing efficiency of the brain. Based on more than 30 years of neuroscience and cognitive research, the Fast ForWord® family of products provides struggling readers with computer-delivered exercises that build the cognitive skills required to read and learn effectively.
Our products are marketed primarily to K-12 schools in the United States. While we recommend our Fast ForWord products as a reading intervention solution for struggling, at-risk, and special education students, schools successfully use Fast ForWord products for students with a wide range of abilities and accomplishments to improve their academic performance.
The ability to read effectively is essential for success in school and in life. Federal education policy has long emphasized the importance of reading; the No Child Left Behind Act of 2002 calls for all students to read at grade level by 2014. According to the United States Department of Education (“USDE”), in 2007, 33% of fourth graders in the United States had reading scores below basic and 67% were not proficient in reading. Among students eligible for free or reduced-price lunches, the USDE found that 83% of fourth graders were not proficient in reading. According to the USDE, between 1992 and 2007, there was only a modest improvement in the proportion of fourth graders reading below the basic level, despite a national focus on reading and significant and increased federal funding.
Since our inception, learners have used our Fast ForWord products over 1.1 million times, and almost 5,200 schools have purchased at least $10,000 of our Fast ForWord product licenses and services.
The Scientific Learning® family of products is distinguished by its basis in independent and peer-reviewed scientific research, specifically in neuroscience. The understanding that the organization of the brain can be modified throughout life through experience - the concept of brain plasticity - led us to create a novel approach to learning. This approach focuses on increasing learning capacity by improving basic cognitive skills through the rigorous and systematic application of neuroscience principles. Our approach uses computer technology because it affords the only practical way to effectively and consistently deliver individualized training to a large number of students simultaneously.
Our Fast ForWord family includes 11 major software products that share this common neuroscience approach, implemented in a variety of reading intervention contexts - early literacy development, foundational language skills, linking spoken language and print, reading skills for grade levels K-5 and adolescent intervention.
Our focus on science continues in our emphasis on generating rigorous proof that our products produce substantial improvements for different types of struggling readers in a variety of settings. Through December 31, 2007, over 145 efficacy studies, including the results from more than 32,000 aggregate participants, demonstrate the academic gains achieved through the Fast ForWord products. These studies show gains for students at all K-12 grade levels, for at-risk students, special education students, English language learners, Title One students, and a variety of other demographic groups. Gains have been demonstrated throughout the United States and in eight other countries. Studies show that these gains endure over time.
To assist educators in getting the best results from their Fast ForWord implementations, we offer a web-delivered data analysis and reporting tool that uses sophisticated algorithms to provide diagnostic and prescriptive information and intervention strategies. This allows educators to track student progress and move students appropriately through the product sequence. To achieve the best results with our products, it is important that educators adhere to our protocols for product use. To support and encourage these best practices in the use of our products, we provide a variety of on-site, web-based and telephone-based services and support.
On January 7, 2008, we completed the acquisition of substantially all of the assets of Soliloquy Learning, including the Reading Assistant product, for $10.7 million in cash. The Scientific Learning Reading Assistant™ combines advanced speech recognition technology with scientifically based courseware to help students strengthen fluency, vocabulary and comprehension to become proficient life-long readers.
Growth Strategy
Our strategic goal is to have our products become widely accepted by educators as a solution that dramatically improves and sustains achievement patterns to meet the needs of a broad spectrum of learners across a variety of academic subjects.
Critical elements of our strategy include:
Ø
Broadening Educator Awareness of Our Products. We intend to increase awareness of our products, including their impact on reading and learning and the research behind them, through a variety of marketing techniques, including an increased number of brain science events that we sponsor or co-sponsor.
Ø
Establishing Rigorously Proven Student Results as an Important Criterion in the Selection of Educational Products. Educators select products for their students based on many factors. We believe that we have demonstrated our products’ positive impact on student achievement with an exceptionally high degree of scientific rigor. Our marketing strategy is designed to focus educators on our results, the depth of the science validating those results, and the importance of those results to their decision-making process.
Ø
Focusing Our Sales Efforts on Key School Districts. We plan on continuing to target those school districts that are struggling with academic under-achievement, have high levels of funding and are headed by strong leaders.
Ø
Increasing Sales Capacity and Productivity. We intend to increase our selling resources, including improving our sales infrastructure and adding additional tools and training programs for our sales force to shorten sales cycles and to increase the number of transactions valued at over $100,000. We have increased our sales force by over 50% since 2004 and plan substantial additional increases this year.
Ø
Emphasizing Post-Sales Support. We believe that effective implementation of our products in compliance with our protocols is important to obtaining the best student results. To help schools follow best practices in their implementations, we plan to continue to emphasize post-sales support, including implementation services and results monitoring, and to continue to explore innovative and cost-effective ways to provide these services.
Ø
Improving and Expanding Our Products. We continue to look at ways to improve our product lines to enhance ease of use and product effectiveness. We introduced the Reading Progress Indicator assessment in June 2007. This product is designed to provide customers with a rapid and convenient way to measure a student’s reading skills before and after use of our Fast ForWord products. We introduced shortened daily protocols for all of our Fast ForWord products and now have consistent protocols across all our Fast ForWord products. The new, shortened protocols are designed for use 30 minutes per day, over a longer overall time period. The limited availability of time and computers in schools is an obstacle to use of our products. By shortening the protocols, we believe that these new protocols will offer our customers valuable additional flexibility.
Ø
Identifying and Expanding into Other New Product Areas. We continue to identify and evaluate potential new applications for our neuroscience-based technology. These include additional products to be marketed specifically for average and gifted students, English language learners, test preparation and improving mathematics skills. While we do not currently have any of these products in development, we may pursue such expansion organically, through acquisitions, or through technology or product licensing agreements.
Ø
Increasing Our Global Presence, Particularly in Asia. We believe that the global demand to learn English is significant, particularly in India and China. As of December 31, 2007, we had 24 value-added resellers, or VARs, and were selling in 42 countries outside the US and Canada, and we plan to increase that number.
Subsequent Event: Acquisition of Reading Assistant
On January 7, 2008 we completed the acquisition of substantially all of the assets of the Soliloquy Learning business, including the Reading Assistant product, from JTT Holdings (d/b/a Soliloquy Learning) for $10.7 million in cash. Reading Assistant is a unique software tool that combines advanced speech verification technology with scientifically-based interventions to help elementary and secondary students strengthen their reading fluency, vocabulary and comprehension in order to become proficient, life-long readers.
We acquired the Reading Assistant product in order to serve a broader range of students, to broaden our offering for English language learners for the US K-12 market as well as the international market, and to further leverage our growing direct sales organization with complementary product offerings. The National Reading Panel has identified five major components of reading and literacy: phonemic awareness, phonics, fluency, vocabulary and comprehension. Our Fast ForWord family of products addresses all of these components, but is particularly strong in phonemic awareness and phonics. The Reading Assistant product adds strength in fluency, vocabulary and comprehension, thereby allowing us to address a broader range of student needs.
Soliloquy Learning was established in 2000, and the Reading Assistant was introduced in 2002. The Reading Assistant has been licensed to more than 800 elementary, middle and high schools at an average price of $6,000 to $7,000 per site. We estimate that in the twelve months ending December 31, 2007, Soliloquy Learning had approximately $1.9 million in revenue, 85% gross margins and a $2.8 million net loss (unaudited).
The Reading Assistant uses the Carnegie Mellon University Sphinx speech recognition engine, which is publicly available. Using this engine, the Soliloquy Learning team developed additional proprietary technology specific to the needs of children and the education environment, which is protected by one issued and seven pending patents.
Reading fluency is the ability of a student to read quickly enough to garner meaning from a text, and is reported to have a high correlation with overall reading proficiency. However, to become a fluent reader, students must frequently read aloud and receive timely feedback and assistance with their reading. Providing effective fluency training for all students is a challenge in the classroom because teachers do not have enough resources and/or time to give the consistent and rigorous one-on-one attention a child needs to improve his or her reading fluency. Reading Assistant addresses this problem by acting as a personal tutor. The program listens as a student reads aloud, monitoring for signs of difficulty and providing immediate feedback and assistance when a child is challenged by a word.
Students at all grade levels can use the Reading Assistant. There are currently two content libraries of stories available for the Reading Assistant, one for elementary school students and one for secondary school students. To use the Reading Assistant, a student sits at a computer station with headphones and an attached microphone. The student is presented with text and as they read the text the computer will correct important mistakes and provide feedback. The student can also ask for assistance in pronouncing a word or getting the meaning of a word. Since the student is reading from a predetermined set of content, the technology is actually performing speech verification versus the more complex task of speech recognition.
Research on the efficacy of this solution has been sponsored through grants from the National Institute of Child Health and Human Development. The Florida Center for Reading Research reviewed the research on the Reading Assistant solution, reporting on a study where students in the experimental group showed statistically significant growth in reading fluency after using the Reading Assistant compared to the control group. The report cited strengths of repeated reading with emphasis on vocabulary and comprehension, rich and robust vocabulary instruction and support, and immediate corrective feedback. They observed no significant weaknesses. The Center also stated that the Reading Assistant is aligned with current reading research.
Customers are using Reading Assistant in a variety of environments including computer labs and classrooms. Typically school sites have used the product at least 10 to 15 minutes a day, three days a week. The teachers and administrators like the fact that students can practice their reading in a nonthreatening environment listening or reading aloud to the computer without fellow students or adults listening.
In addition to the Reading Assistant product, we have added 19 staff from the Reading Assistant team. They will remain in Waltham, Massachusetts and will be responsible for continuing to build and maintain the speech verification technology system as well as developing additional content.
We believe that teachers, schools and districts will want a steady stream of fresh content for the Reading Assistant for students to use in building their reading fluency across all grades and content areas, and therefore developing additional content will be a priority. The addition of the Reading Assistant also brings new opportunities to develop new speech recognition products that can directly link to our Fast ForWord Language and Fast ForWord Reading products. In addition, we plan to integrate the Reading Assistant with our Progress Tracker reporting platform to provide a single platform across our product portfolio.
Reading Assistant will be sold through our existing sales channels. We plan to integrate the Reading Assistant into our marketing efforts, including our Brain Events. We expect to sell Reading Assistant both separately and in bundles with our Fast ForWord products.
The majority of Soliloquy Learning’s business came from sales to K-12 public schools, however they also had an OEM business they used to fund development. Reading Assistant will compete in the same supplemental and interventional education market as Fast ForWord products. We also may encounter competition from these OEMs who will be selling products based on similar technology.
Markets
Our products are available worldwide to educational institutions, speech and language clinics, and learning and tutorial centers. Since our inception through December 31, 2007, learners have used our Fast ForWord products over 1.1 million times, an increase of 35% over year-end 2006.
United States K-12 Market
Our sales are concentrated in K-12 schools in the United States, which in 2007 were estimated to serve approximately 55.8 million students. In each of the last three fiscal years, the U.S. K-12 sector has represented more than 90% of our revenue. Almost 5,200 schools have purchased at least $10,000 of our Fast ForWord product licenses and services, compared to 4,500 at the end of 2006. While our installed base is growing, these 5,200 schools represent a small fraction of the nearly 125,000 K-12 schools in the United States.
We market our products primarily as a reading intervention solution, to be used as an interventional or remedial supplement to existing curriculum materials for struggling, at-risk, English language learners (“ELL”), and special education students, at both the elementary and secondary school levels to improve reading and learning. Despite a national focus on reading and increased federal funding to improve reading proficiency and school district accountability, independent evaluations of student performance have demonstrated little improvement in reading results. According to the USDE, in 2005, 33% of fourth graders in the United States had below basic reading scores and 67% were not proficient in reading, and between 1992 and 2007, there was only a modest improvement in the proportion of fourth graders performing at the “below basic” level. Among students eligible for free or reduced-price lunches, the USDE found that 83% of fourth graders were not proficient in reading.
Sales of our products are included in the growing supplemental education materials segment of the overall education materials market. Simba Information’s Publishing for the PreK-12 Market 2007 - 2008 (April 2007) estimates that:
Ø
The total market for K-12 instructional materials is $8.58 billion, growing at 4.2%
Ø
The supplemental materials segment of that market is $4.29 billion
Ø
The fastest growing supplemental market, technology based electronic courseware, is $856 million and expected to grow 9.4%
We do not compete in the separate basal materials market (a $3.5 billion market, according to Simba), which consists primarily of textbook programs that include student editions, teacher editions and companion materials to teach particular scope and sequence of a subject area for a span of grades. We also do not compete in the market for formative, summative or clinical assessments, estimated by Simba to be $1.22 billion in 2007, or in the market for school library and reference products.
The educational materials market is expected to continue to grow, driven by several factors:
Ø
Increasing enrollment of pre-K-12 students, projected by the National Center for Education Statistics of the U.S. Department of Education to grow from 55.8 million students in 2007 to 59.8 million students in 2016.
Ø
Performance and educator accountability requirements of federal legislation, including the No Child Left Behind Act of 2002, and persistent achievement gaps based primarily on income and ethnicity which are driving the use and growth of programs addressing the needs of struggling readers.
Ø
Increase in current expenditures per student. Current expenditures per pupil in constant 2004/05 dollars increased 23% from 1991/92 to 2003/04. From 2003/04 to 2016/17, current expenditures in constant 2004/05 dollars per pupil are projected to increase 30 percent, to approximately $11,000.
The pre-K-12 education materials market includes approximately 14,000 public school districts, 97,000 public schools and 28,000 private schools. Purchasing decisions for Fast ForWord products are primarily made by district level administrators.
No Child Left Behind Act of
The Elementary and Secondary Education Act of 2001, commonly known as the No Child Left Behind Act (“NCLB”), concentrates on increased accountability in the public school system. The bill focuses on reducing the achievement gap between students of different ethnic backgrounds and ensuring that every child can read at his or her grade level. The primary influence of NCLB was to make schools and district more accountable for performance through testing and reporting of student progress at the student sub-group level - English Language Learners, Title 1 Students and Special Needs students are all measured within their sub-groups to ensure performance is being achieved. As a result, schools are demanding proven, research-based reading interventions that can bring these subgroups to grade level proficiency quickly.
Because of our ongoing commitment to proven, research-based reading interventions, we continue to be ideally positioned to offer schools compelling solutions to bring all students up to grade level proficiency quickly. Our family of products is based on more than 30 years of neuroscience and cognitive research the results of which are supported by independent academic researchers and school districts, as well as by our founding scientists and our company’s own studies.
The No Child Left Behind Act is scheduled for reauthorization after the 2008 presidential election. Some aspects of No Child Left Behind, in particular the emphasis on testing by sub-group and the consequences of failing to meet specified achievement criteria, have been controversial. We believe that while there may be some changes to No Child Left Behind, these changes will not decrease the need to improve reading performance, the market for our products or the federal funding supporting elementary and secondary education.
Accountability
Parents and policy makers are exerting greater pressure to hold teachers and administrators accountable for student performance. School report cards, sanctions for lack of learner improvement, financial incentives, school vouchers, extended day programs, enhanced intervention services, professional development for teachers, and supplementary educational services alternatives are some of the techniques used by states and the federal government to increase local educator accountability and student performance. The Fast ForWord products help schools respond to these accountability pressures in a variety of ways, including:
Ø
Our products can improve academic achievement in students for whom other approaches have failed.
Ø
Our products can be used to increase the scores of children who are “on the bubble” (just below a desired score on an achievement test).
Ø
Educators can use Progress Tracker to track the progress of students by demographic group, responding to the requirement to achieve Adequate Yearly Progress for all defined groups.
Funding Sources
Funding for educational materials comes from a variety of federal, state and local sources. According to the U.S. Census Bureau, in school year 2004/2005, 47% of district funding was from state sources, 44% from local sources and 9% from federal sources. The federal government spent $36.8 billion on elementary and secondary schools in 2007, up from $15 billion in 2000. Some funding sources are allocated for specific uses, such as improving reading performance, depending on the policy objectives of the funding source.
Federal funds are a critical resource to help school districts address the needs of the most challenged learners. The primary federal support for education dates back to 1965 with the introduction of the Elementary and Secondary Education Act. We believe that a significant proportion of our sales are funded by two key federal sources that support struggling readers. Title One supplements funding for schools with low income students; IDEA provides funding for special education students. These programs are projected to total $25.4 billion for fiscal year 2008 compared to $16.1 billion in 2001, an increase of 58%.
Other Markets
In addition to selling to K-12 schools, we also sell to and through private practice professionals and learning centers. These speech and language and other professionals recommend the use of our products to appropriate clients and then supervise the use of the software, often in connection with their other services. In 2007, approximately 600 non-school professionals and entities in the United States and Canada used our products. While this business is a small proportion of our overall business and has been essentially flat over the last several years, the private practice professionals nevertheless remain significant to us. They were our first market, and many have extensive knowledge about our products and their use that can be valuable for us and our customers. These professionals sometimes provide contract services to schools and from time to time recommend our products for students in those schools.
Sales to countries other than the United States and Canada are a small but growing part of our business. We are developing a network of value added representatives to serve these markets. Since our inception, international participants have used our products more than 11,800 times. During 2007, Fast ForWord products were marketed to customers in 42 countries, up from 29 in 2006. As of December 31, 2007, we were represented by 24 value-added representatives, up from 21 at year end 2006. Research studies of the results of Fast ForWord users in Australia, Germany, Singapore, India, Ireland and the United Kingdom have demonstrated the efficacy of our products. International revenues represented approximately 2% of our total revenues in 2007.
Our strategy for international markets thus far has been conservative, so that we do not divert resources from our U.S. K-12 market, but we believe the potential opportunity is significant. Outside the United States and Canada, our products are used in three primary applications: in tutoring and learning centers to strengthen academic skills, by clinical professionals with relatively impaired children, and to assist in the acquisition of English as a second language. English has become the second language of choice in most countries, with approximately 340 million people speaking English worldwide. About one-fourth to one-third of the population worldwide now understand and speak English to some degree, and English is the international language of business, travel, and diplomacy. While our products do not provide all the components necessary to teach English to non-native speakers, they have been demonstrated to be extremely effective in assisting in English language instruction, through building the necessary underlying cognitive, acoustic processing, phonological and other skills needed to learn and speak English fluently.
We continue to explore and evaluate other potential markets where our products can help struggling learners, including correctional institutions and tutoring centers.
Products
Our Fast ForWord family of products consists of award-winning software that combines neuroscience, cognitive science and computer technology to change the neurological patterns in students’ brains. Our products build learning capacity by systematically and rigorously applying proven neuroscience principles to develop the cognitive skills required to read and learn effectively, using exercises based on language and reading skills. The results from our products are fast, effective and enduring; results have been demonstrated through brain imaging studies, changes in achievement on standardized reading tests and more than 145 efficacy studies.
Cognitive Skills Development
Reading and learning require a variety of foundational cognitive skills, all functioning together. The Fast ForWord products build learning capacity by developing the prerequisite skills that enable students to take greater advantage of their reading and other academic instruction and improve their reading proficiency. Fast ForWord products do this by building these cognitive skills, including memory, attention, processing and sequencing (we refer to these as Learning MAPs).
Memory. Working memory is the aspect of memory that allows one to keep information available while thinking about meanings and relationships, and is used in sentence and paragraph comprehension, remembering instructions and reasoning. The Fast ForWord exercises systematically vary the amount of information that must be retained to successfully complete the exercise task, using individually adaptive methods to gradually expand the working memory demands of the task.
Attention. Attention is the ability to focus on tasks and ignore distractions. Every exercise in our product family requires selective and focused attention in order to advance. Specific vigilance tasks require sustained attention over progressively longer time frames, building the attentional skills needed in all reading and learning.
Processing. Processing means the ability to address information such as images and sounds quickly enough to discriminate their differences. Processing skills are an essential prerequisite for phonemic awareness (the ability to distinguish among and manipulate the smallest sounds in language that can change meaning) and reading. Our exercises build processing rate and accuracy in the skills addressed by the exercises. For example, exercises in our Fast ForWord Language to Reading and Literacy Advanced products focus on the accuracy and rate of processing for letter-sound correspondence, leading to the automaticity in those skills needed for reading.
Sequencing. Sequencing refers to the ability to quickly and accurately determine the identity of specific stimuli and the order in which the stimuli occur. This ability is supported by both working and longer-term memory, attention, and processing. Sequencing of auditory, language and written information is critical for the accurate understanding of meaning. The Fast ForWord exercises systematically and individually adapt the complexity of the sequencing tasks needed to develop phonemic awareness, word fluency, oral and reading comprehension, and other critical cognitive operations.
Neuroscience-Based Learning Principles
The Fast ForWord products apply learning principles that have been established through neuroscience and cognitive research as being critical to learning new tasks and establishing rapid change in brain function: frequency and intensity, adaptivity, simultaneous development, and timely motivation. In our marketing, we refer to our application of these principles as F.A.S.T. Power Learning™.
Frequency and Intensity: The cortex of the human brain contains millions of neurons arranged in regions that represent our sensory systems, control our motor systems and provide for higher-order associative interactions. These regions contain networks of neurons that connect within and between regions. These functional networks develop and maintain their connections through a process that is driven by neural activity. The stronger the neural activity, the stronger the network becomes. As a result, completing a series of learning tasks in frequent, intense sessions is needed to make the changes in brain functioning that enhance learning. Our product use protocols call for customers to use the products five days a week, between 30 and 100 minutes (depending on the product) per day, providing the frequency and intensity needed. The Fast ForWord products also contain substantially more learning activities per 50 minute session than do other computer-based reading intervention products, providing more intense neural activity and therefore greater effectiveness.
Adaptivity: The mechanisms of brain plasticity are best engaged in learning a new task when new populations or new areas of neurons are engaged. Continually adjusting the learning tasks to become progressively more difficult provides better cortical activation for learning. The Fast ForWord products use sophisticated algorithms to analyze student learning data using a complex set of rules. These algorithms regulate the products’ speech modification rules and otherwise adjust content exposure to advance the individual student through the products at a rate specifically tailored to that student. The products adjust content exposure in a variety of ways. For example, many of the exercises automatically adjust the specific content presented to the student so that the student can make correct responses approximately 80% of the time for each discrete skill. This adjustment is designed to keep cortical
Page
activation up and to keep the exercises challenging and engaging, while allowing the student to experience a feeling of accomplishment and to avoid the frequent failure that can discourage a student’s learning.
Simultaneous Development: Complex behaviors require the coincident and sequential engagement of multiple cortical systems. The Fast ForWord products simultaneously develop both major and supporting cognitive skills for enduring learning improvements. While each exercise is designed to develop underlying cognitive skills such as memory, attention, processing and sequencing, it also focuses on a specific set of reading or language tasks.
Timely Motivation: A critical factor in strengthening neural connections, and therefore maximizing critical learning changes, is the input from the neuromodulatory reward systems that are activated by meaningful consequences of behavior. These reward systems need to be activated within tens of milliseconds of the neural synaptic activity to maximize the potential for synaptic strengthening. In the Fast ForWord exercises, learners are rewarded for a correct answer quickly, within this critical time frame, and on their first attempt only, in order to drive learning behavior. To keep students active and engaged, the products also feature a bonus point system and the delivery of special animations that signify milestones as students progress.
Products in the Fast ForWord Family
Since 1997, when we introduced the first Fast ForWord product, our product family has expanded to 11 major software offerings. During 2007, our Fast ForWord family of products accounted for 67% of revenue. The software products function with a wide variety of hardware and software configurations and are designed to work with the computer technology widely available in schools.
Product
Description
Language Series Products
Fast ForWord
Language Basics
Fast ForWord Language Basics targets early literacy development, building visual attention, auditory discrimination and sustained auditory attention, using exercises that improve sound sequencing skills, fine motor skills, hand-eye coordination, pattern recognition and color and shape identification.
Fast ForWord
Language
Our first product, Fast ForWord Language builds learning capacity using exercises that specifically focus on oral language comprehension and listening, including phonological awareness (the understanding that words are composed of sounds and the ability to identify and manipulate the sounds of language), listening accuracy and comprehension, working memory, and familiarity with language structures. The Fast ForWord Language product uses acoustically modified speech, which stretches and emphasizes particular sounds in an adaptive manner, to help children learn to quickly isolate and recognize individual speech sounds, an underlying skill critical to reading.
Fast ForWord
Language to
Reading
Fast ForWord Language to Reading software builds learning capacity through improving cognitive skills while helping students make the link between spoken and written language, using exercises that focus on listening comprehension, sound-letter recognition, phonological awareness, beginning word recognition and English language conventions.
Fast ForWord to
Literacy
The Fast ForWord to Literacy product is specifically designed for adolescents and adults who lack reading proficiency. Its content and exercises are similar to those in the Fast ForWord Language product, but have been adapted to maximize impact for adolescents and English language learners based on actual learning results from those groups. Using graphics, characters and themes appealing to adolescents, the product progressively increases the demand on cognitive skills. This product replaces our earlier Fast ForWord Middle & High product.
Fast ForWord to
Literacy
Advanced
Fast ForWord to Literacy Advanced software includes content and exercises similar to those in the Fast ForWord Language to Reading software. Like the Literacy product, the content has been tuned to maximize impact using actual learning results, and the user interface is designed to appeal to adolescents. The product includes age-targeted exercises that emphasize phonemic awareness, decoding, word recognition, sequential and inferential comprehension and the ability to sequence multi-step instructions.
Page
Reading Series Products
The Fast ForWord to Reading series of products builds learning capacity through developing cognitive skills using exercises focused on critical reading abilities. The Reading Series exercises focus on phonemic awareness, phonics and decoding, spelling, vocabulary, fluency and comprehension. The content of each product is correlated to the reading standards for the end of the grade level indicated by the product number. (Reading Prep is correlated to kindergarten.) However, the increasingly demanding cognitive complexity of the products can take the learner well beyond that grade level.
Product
Description
Fast ForWord to
Reading Prep
The Fast ForWord to Reading Prep product builds learning capacity through exercises that prepare the student for reading, focusing on phonemic identification, categorization and blending, letter names, sound and letter correspondence, rapid letter/word recognition, and oral vocabulary.
Fast ForWord to
Reading 1
The Fast ForWord to Reading 1 product builds learning capacity while introducing familiarity with print. The exercises emphasize sound-letter correspondence, rapid letter-word comprehension, high-frequency words and beginning print comprehension.
Fast ForWord to
Reading 2
Fast ForWord to Reading 2 software builds learning capacity through exercises that build a spectrum of reading skills, focusing on comprehension at the sentence and paragraph level, vocabulary, spelling, punctuation and capitalization. The product continues work in phonics and decoding and introduces morphological structures such as prefixes and suffixes. Morphology relates to the use of words, letters, and letter combinations that change the meaning of a word.
Fast ForWord to
Reading 3
The Fast ForWord to Reading 3 product builds learning capacity by continuing to improve cognitive skills through exercises that focus on increasing fluency. The exercises focus on semantic, syntactic, phonological and morphological categories, phonics, spelling and comprehension. Sentences in the exercise incorporate a high level of syntactic complexity. Syntax relates to how grammatical markers and words are combined to make meaningful sentences.
Fast ForWord to
Reading 4
Fast ForWord to Reading 4 software builds learning capacity by improving cognitive skills in the context of a focus on text interpretation. The exercises focus on comprehension and vocabulary, and build word skills relating to compound works, prefixes and homophones.
Fast ForWord to
Reading 5
The Fast ForWord to Reading 5 product builds learning capacity by improving cognitive skills while strengthening advanced comprehension strategies. The exercises carry a significant working memory load, as they build vocabulary, improve critical thinking and abstract reasoning, improve composition skills, and focus on accuracy, fluency and comprehension.
Product
Description
Internet-Based Tools
Progress Tracker
Progress Tracker, our Internet-based data analysis and reporting tool, analyzes student learning results to provide diagnostic and prescriptive intervention information and allows educators to track and report their students’ learning progress. It also provides information aligning the Fast ForWord products to basal reading programs and correlating the products to state standards. Progress Tracker generates status flags using sophisticated algorithms to analyze student learning data with a complex set of rules partially based on past data patterns. These status flags alert the educator when intervention is necessary for a student, and suggest to the educator when to move the student to a lower or higher level product or to complete product use. Progress Tracker provides detailed reports at the student, classroom, school, and district level, and can be reported by subgroup, providing a tool for educators to analyze their progress towards the Annual Yearly Progress requirements mandated by No Child Left Behind. Customers can configure the system to send automatic emails to parents, teachers, administrators or others to provide easy periodic updates. Progress Tracker also provides the ability to collect behavioral survey data from teachers and parents prior to and after product use.
In June 2007, we added Reading Progress Indicator to our Progress Tracker system. Reading Progress Indicator is a reliable and valid assessment of a student’s reading skills. It is designed to be quick and convenient to administer before and after Fast ForWord product use, to rapidly demonstrate the effectiveness of our products.
Product Effectiveness
Research by our school district customers, independent academics and our own scientists has demonstrated that Fast ForWord products improve language and reading skills across a broad spectrum of demographic groups, and we continue to accumulate outcomes data from students in classrooms across the country. To date, more than 145 research studies, including the results from more than 32,000 aggregate participants, demonstrate the academic gains achieved through the Fast ForWord products. Published studies show outcomes from more than 455 learning organizations.
As of December 31, 2007, research substantiating the outcomes that can be achieved through using the Fast ForWord products includes:
By region
Skills
Students
Other
Northeast (38
reports)
Connecticut,
Delaware, Maryland,
Massachusetts, New
Jersey, New York,
Pennsylvania, Rhode
Island, Virginia
State Assessments
(39 reports)
BLT, DIBELS, DRP,
DSTP, EOG, FCAT,
ISAT, ITBS, LEAP,
MCAS, MCT, MSA,
OAT, OPT, SAT-9,
TAAS, TAKS,
TCAP, Terra Nova,
TPRI
At-Risk Learners
(16 reports)
Oral Language,
Phoneme Awareness,
30 Minute Protocol
Brain Plasticity is well-founded in research. More than 30,000 articles relating to research on “Brain Plasticity” for the years 1967-2007 have been indexed by scholar.google.com.
Page
By region
Skills
Students
Other
South (22 reports)
Alabama, Arkansas,
Florida, Georgia,
Louisiana,
Mississippi, North
Carolina, South
Carolina, Tennessee
Reading Skills
(119 reports)
Phoneme Awareness,
Reading
Comprehension,
Vocabulary, Fluency,
Listening
Comprehension
Title I Schools
(28 reports)
Reading achievement
results for
elementary, middle
and secondary
schools
Independent reviews substantiate the research basis of the Fast ForWord products. Independent reviews of the Fast ForWord research have been published by the USDE’s What Works Clearinghouse, the Metiri Group, the Florida Center for Reading Research and the Milken Family Foundation.
Midwest (30
reports)
Illinois, Indiana,
Kentucky, Michigan,
Minnesota, Missouri,
Ohio, South Dakota,
Wisconsin
Cognitive Skills
(11 reports)
Memory, Attention,
Processing,
Sequencing
English Language
Learners (7 reports)
Reading skills and
achievement for
elementary, middle
and secondary
schools
Fast ForWord product effectiveness research continues to grow. Research demonstrating the positive impact of Fast ForWord software has resulted in more than 145 research reports based on data from more than 32,000 students at 455 schools.
West (44 reports)
Alaska, Arizona,
Arkansas, California,
Idaho, Kansas,
Montana, New
Mexico, Oklahoma,
Texas, Washington,
Wyoming
Longitudinal
Studies (4 reports)
State Assessments,
Oral Language,
Reading Skills
Special Education
Recipients
(22 reports)
Dyslexia,
Autism/PDD,
Attention Deficit
Disorder, Language
Impairments,
Developmentally
Delayed
Substantial & ongoing research impact by contributing scientists. Scientists directly involved in the development of the Fast ForWord products have authored or co-authored more than 435 articles and book chapters in the fields of brain plasticity, neuropsychology and cognitive development. This foundational research has been cited more than 4,200 times in the scientific literature.
International
Studies (8 reports)
Australia, Canada,
Germany, India,
Ireland, Singapore,
United Kingdom
Language Skills
(33 reports)
Language Arts, Oral
Language, Listening,
Speaking, Syntax,
Oral Grammar, Oral
Vocabulary
Other Populations
(14 reports)
Gifted & Talented,
Native Americans,
Young Adults,
Adjudicated
Highlights of this research include:
Ø
Twenty-five studies involving more than 2,600 children have demonstrated Fast ForWord efficacy using well-controlled experimental or quasi-experimental study conditions and reliable and valid performance measures, including studies that use randomized control groups.
Ø
The What Works Clearinghouse, established by the U.S. Department of Education’s Institute of Education Sciences, has reviewed the research on the effect of the Fast ForWord products on English Language Learners and Beginning Readers. Based upon studies that meet the What Works Clearinghouse’s high standards, the Clearinghouse has determined that the Fast ForWord products have positive effects.
Ø
The underlying basis for these achievement gains is demonstrated by a Stanford University study published in 2003 in the Proceedings of the National Academy of Sciences. This study confirmed that after using the Fast ForWord Language product, students on average experienced significant changes in brain activation patterns as shown by functional magnetic resonance imaging. On average, the Fast ForWord participants also showed significant gains on measures of language and reading performance.
Ø
In an effort to determine the cause of the phonological deficit frequently seen in children with developmental dyslexia, researchers from Harvard, MIT, Dartmouth, Rutgers, and Stanford investigated differences in the cortical activity of typical reading children and children with
Page
developmental dyslexia as they processed rapidly changing sounds. The results were published in Restorative Neurology and Neuroscience in 2007 and demonstrated that typical reading children process slowly and rapidly changing sounds in different cortical regions, while children with developmental dyslexia process them in the same region. Children with developmental dyslexia who underwent remediation with Fast ForWord products increased their language and reading skills, and the way they processed rapidly changing sounds changed, becoming more similar to that of typical readers.
Implementation
We market the Fast ForWord products primarily as an intervention solution, and our customers most frequently use the products with students who are struggling. However, some customers use the Fast ForWord software with all of their students. We provide our customers with a placement chart that, based on a students grade level, achievement, and demographics, recommends which product the student should use. We suggest that students use two Fast ForWord products per year.
Neuroscience teaches us that to facilitate the brain changes that lead to enhanced learning, the student needs to complete a set of learning tasks in a frequent, intense timeframe. To provide that intensity and frequency, we have established product use protocols for our Fast ForWord products that call for customers to use the products five days a week, between 30 and 90 minutes per day, for a period of generally between four and twelve weeks (depending on the student and the product). It can be challenging for educators to dedicate that much time to Fast ForWord use out of a limited and already crowded school day. Fast ForWord implementation also competes with other software applications for the limited number of school computers. To address this challenge in 2007 we introduced protocols for all of our products designed for use 30 minutes per day. We believe the addition of this shorter daily protocol will offer our customers valuable additional flexibility.
Our products are most frequently used in a computer lab setting, either a lab entirely devoted to Fast ForWord product use or a lab shared with other applications. A lab setting is likely to provide the appropriate kind of quiet focused atmosphere that is best for Fast ForWord use. Some customers have effectively used the products, especially the Reading series products, in regular classrooms. We expect that the 30 minute protocols will facilitate use in regular classrooms.
We encourage our customers to use the products with as many students as their scheduling and computer resources permit. In 2007, our customers with full site licenses to the Gateway Edition products averaged 103 students per school using the products, up from 98 in 2006.
License Terms
We license our products in a variety of configurations to meet the customer’s needs. Schools typically purchase site or workstation licenses, which are available either as a perpetual license or for a limited term. Most customers also purchase implementation services, which we believe are important to encourage successful use of the products. Our approximate license package list prices range from approximately $10,000 to $85,000 per site, depending on the number of products, the number of workstations, the duration of the license and the volume purchased.
Products licensed for administration by private practice professionals are generally purchased on a per product per student basis. Our Language and Reading series products presently list for between $500 and $900 per product per student. The private practice professional charges separately for his or her services. Hospitals, clinics and learning centers purchase both per-product per-student licenses and site or workstation licenses, depending on their size and needs.
Fast ForWord Services and Support
We believe that the training and implementation support provided by our service personnel is important to achieving appropriate product use in schools, where a limited school day and competing priorities makes it challenging for educators to devote the time and resources needed for a solid implementation. The Fast ForWord products employ science and research unfamiliar to many educators, and understanding these principles is key to successful and sustained implementations. Our service professionals are highly trained and skilled at building the necessary knowledge and best practices. In 2007, services, support and Progress Tracker accounted for 33% of revenue, compared to 27% in 2006 and 25% in 2005. As of December 31, 2007, our service and support organization
Page
included 58 employees supplemented by 34 independent contractors who provide on-site customer training, consulting and technical services.
Services
To facilitate effective implementation, we offer on-site product training, technical installation, implementation management, consulting, and professional development services. To help our customers obtain the best possible student achievement results, our product training and professional development sessions provide an extensive hands-on introduction to our products, “best practices” implementation strategies, and an introduction to the science behind our products. We also offer implementation management services, which provide administrators a detailed overview of the implementation at each of their schools, and consulting on data analysis and interpretation, intervention and motivation strategies, connecting with classroom teachers and other topics of interest to the customer.
We host national and regional Circle of Learning user conferences and a spectrum of forums, workshops, and seminars for customers and prospective customers. At these gatherings, speakers provide information on advances in neuroscience and learning, and current customers offer actual case studies on how our products impact student achievement. These sessions also provide our customers with opportunities to network and develop informal support relationships.
Support
For customers who purchase our support services, we provide progress monitoring, software technical update releases, and extensive telephone, email and web-based support. Our progress monitoring services provide customers on-going remote monitoring of their students’ progress by our staff, with periodic out-bound telephone contact tailored to the customer’s level of implementation success. Our Customer Connect Website provides extensive implementation and technical resources, together with Web-based seminars. In our annual independent customer surveys, customers using Fast ForWord products gave excellent ratings to the support they received and the professionalism of our support team.
In 2006, we moved our basic support services from the outside vendor that we had used for many years to our own We Care support center located in Tucson, Arizona. We made this change to enhance our service levels, increase the integration between support personnel and our technical organization, and contain costs. We believe this move has met these objectives. At year end 2007 we had 20 support professionals, compared to 15 at year end 2006.
Warranty
We generally provide a warranty that our software products operate substantially as described in the manuals and guides that accompany the software for a period of 90 days. The warranty excludes damage from misuse, accident, and certain other circumstances. To date, we have not experienced any significant warranty expense.
Sales and Marketing
We sell to our principal market, K-12 school districts throughout the United States, primarily using a direct sales force. During the past two years, an important part of our strategy has been to increase the size as well as the productivity of our direct sales force. In 2007, our average number of field sales representatives was 49, an increase of approximately 17% over 2006. We plan to continue to increase our field sales force. (We calculate the annual average of field representatives by averaging the number of representatives at the end of each quarter.)
Our field sales personnel typically are experienced professionals with backgrounds in selling technology-based curriculum products to the K-12 market. Most bring strong relationships with educators built over many years. We support our sales representatives with a strong field sales management team with extensive experience in this market and with strategic consultants, who frequently are retired school district superintendents and other senior district administrators, and who have extensive experience and relationships in K-12 education. To reach smaller and rural schools, to a limited extent we also sell our products through school consortiums and regional service centers.
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. In 2007 we continued to focus our sales force on multi-site sales. As a result, in the second quarter of 2007, we closed the second largest transaction in our
Page
history with Duval County Public schools. As a result of this transaction and other transactions closed this year and in prior years, revenues from Duval County for 2007 were more than 10% of our revenues for the year.
A critical component of our marketing strategy is our brain science events. These are Company-sponsored or cosponsored events that provide us with a significant period of time in which to explain our neuroscience approach and achievement results, and have been particularly effective selling opportunities. We also conduct direct marketing campaigns and participate in selected trade shows. In our marketing, we emphasize the unique characteristics of our solution, our neuroscience research basis, and our proven impact on student achievement.
We sell to clinical professionals and learning centers principally through direct marketing (mail, web and telesales) and conferences (both industry conferences and an annual forum we conduct ourselves).
We are also building a network of independent value-added representatives outside North America. As of December 31, 2007, we had relationships with 24 representatives, compared to 21 at year end 2006. To date, booked sales outside North America have not been significant. We are building this channel to capitalize on the growing demand for English fluency around the world. We believe that Fast ForWord products offer unique value in quickly “rewiring” the brain for English. We also believe the international market has large potential growth opportunities, and we are positioning to take advantage of these in the future.
Competition
Districts and schools employ a wide variety of learning intervention programs and methods for their struggling students. The market for supplemental and interventional educational products is fragmented and competitive, with no single company or product with a dominant market share. We presently have a small share of the reading intervention supplemental market.
The critical factor for K-12 school districts is the perceived ability of the product to further the district’s instructional goals. Attributes that influence the district’s assessment of this factor include the ability to deliver measurable improvements in student achievement, cost, reputation, existing relationships with customers, completeness of the product offering, ability to provide effective and efficient product implementation, and ability to work with the other components of the school curriculum. We believe that generally we compete favorably on the basis of these factors.
Our patented products are highly differentiated by their neuroscience basis and their focus on the development of learning capacity through improving cognitive skills. While we therefore have little direct competition, we do compete vigorously for available funding against other companies offering educational software and other language and reading programs, as well as with providers of traditional methods of teaching language and reading. Many of the companies providing these competitive offerings are much larger than us, 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. Competitors may enter our market segment and offer actual or claimed results similar to those achieved by our products. In addition, although the traditional approaches to language and reading are fundamentally different from the approach we take, the traditional methods are more widely known and accepted and, therefore, represent significant competition for available funds.
Product Development; New Products
The markets in which we compete are characterized by frequent product introductions and evolving educational standards and approaches. Our future success will depend in part on our ability to continue to enhance and update our existing products or to develop and successfully introduce new products.
Our research and development expenses were approximately $4.5 million for the year ended December 31, 2007, and $4.1 million and $3.9 million for the years ended December 31, 2006 and, 2005, respectively. As of December 31, 2007, 22 of our employees were engaged in research and development activities, which include both product development and outcomes research.
Development Strategy
Over the past several years, our development efforts have focused on broadening our product solution and making our products more effective and easier to use in the school environment. Since introducing the first Fast ForWord
Page
product, we have broadened our product line to include 11 neuroscience-based intervention products, and a robust suite of Internet-based information tools and introduced a major new architecture for our major products.
Major Product Introductions
Our products rely on market-tested technology and uniform platforms and are developed in a shared authoring environment, so that customers can easily broaden their Fast ForWord implementations, as well as move students easily among our products.
A critical component of our process for enhancing our products and developing new products is our analysis of the data uploaded to us through our Progress Tracker tool. This data is a unique and valuable resource. Analyzing the patterns among groups of participants allows us to understand, in detail, how students generally progress, where students have difficulty, where intervention might be appropriate, and how these patterns differ by demographic group. We can also identify trends in product use and efficacy that can help us develop product improvements for specific sub-groups of learners.
Reading Progress Indicator
In June 2007, we introduced the Reading Progress Indicator assessment as a new component in our Progress Tracker data system offering. Reading Progress Indicator is designed to provide customers with a rapid and convenient way to measure students’ reading skills before and after Fast ForWord product use. The Reading Progress Indicator assessment was developed with and licensed from an independent third party, Bookette Software Company.
Reading Progress Indicator is designed to be a reliable and validated assessment of a student’s reading skills that is correlated to nationally recognized normed assessments. Reading Progress Indicator will show an overall reading score in the form of grade equivalents, normal curve equivalents and percentiles. When a customer has licensed Progress Tracker with Reading Progress Indicator, the assessment will be launched for each student when the student begins and completes use of the Fast ForWord product. The assessment will include two forms for each of four grade level tests.
Product Enhancements
Our strategy is to devote much of our current development resources to three major product enhancement projects:
Ø
Updated Technology: We are in the process of updating our products using a new development platform, which will allow us to make our user interfaces more appealing to students, permit better integration between our products and newer operating systems, and give us the capability of delivering our products over a web portal. Our two newest products, Fast ForWord to Literacy and Fast ForWord
Page
to Literacy Advanced were created using the Flash authoring environment for multi-media applications, and we have begun the process of converting all of our major products to Flash.
Ø
Major New Editions of Fast ForWord Language and Fast ForWord Language to Reading: We have also begun major new editions of our two oldest products, Fast ForWord Language and Fast ForWord Language to Reading. In this process, we are mining our student results database to find adjustments that will increase the efficiency and effectiveness of the products, updating the graphical interface and converting the authoring environment to Flash.
Ø
Enhancements in Customer Use: We are currently doing research to see if we can develop protocols for use of our Fast ForWord products that would be effective if used less than 5 days a week. If these protocols can be developed and found effective it could possible open additional markets such as learning centers or after school use, and make for easier implementations. We are working on a placement tool based on the Reading Progress Indicator assessment that will recommend a starting and a learning path for an individual student based on their achievement and other factors.
We have not announced any release dates for product upgrades and enhancements and we plan to charge for new products or upgrades, where applicable.
New Products
We continue to evaluate potential new applications for our neuroscience-based technology, and have identified a number of potential development areas, including additional products to be marketed specifically for average and gifted students, English language learners, test preparation and improving mathematics skills. While studies have shown that the current Fast ForWord products improve the math performance of learners by developing the foundational skills of memory, attention processing and sequencing, there are other cognitive skills also critical to math proficiency. We are in the early stages of evaluating these potential product areas and have not reached any decision with respect to whether to proceed in a particular area.
Unexpected challenges could make these and other potential 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. We cannot guarantee that we will meet our intended introduction schedule for future products, or that future products will be free of technical issues or that they will be well received in the market.
Intellectual Property
Our intellectual property strategy addresses both product technology and product concepts. Our policy is to protect our proprietary rights in our products and technology through a combination of patents, trademarks, copyrights, trade secret laws, confidentiality procedures, and contractual provisions.
At December 31, 2007, we held the rights to 79 issued patents and 30 pending applications. These include 55 issued U.S. patents and 20 pending U.S. applications that we own or co-own. We also held seven issued patents from other countries and had nine applications pending abroad. We were the exclusive licensee under 11 issued U.S. patents, six issued foreign patents, and one pending foreign patent applications. The U.S. patents expire between 2014 and 2019.
We also have ten U.S. trademark registrations, including registrations for marks including “Fast ForWord,” our most important trademark.
The 18 patents and applications that we license are owned by the Regents of the University of California, or the Regents, and Rutgers, the State University of New Jersey, and relate to the basic speech and sound modification and adaptive technology developed at those institutions. In 2007, approximately 78% of our product booked sales was derived from selling products that use the licensed inventions. This license is exclusive and extends for the life of the University patents, which expire in 2014, subject to the right of the Regents to terminate in case of default and our right to terminate at any time upon 60 days written notice. If we were to lose our rights under this license, it would materially harm our business. This license requires payment of royalties based upon cumulative net booked sales of our products, subject to certain minimum royalty amounts. In 2006 and each year thereafter, the minimum
Page
royalty payment is $150,000. In 2007, 2006 and 2005, we had approximately $1,028,000, $868,000, and $1,048,000, respectively in royalty expense under the license.
Posit Science Corporation
In September 2003, we transferred certain of our technology to Posit Science Corporation, or PSC, for use in the healthcare field. The initial focus of PSC is on products to combat age-related cognitive decline and to enhance cognitive abilities as people age. The transaction included a license of the patents we own and certain software we developed, a sublicense of the patents we license from the universities, and the sale of some research-related assets. All of the rights licensed to PSC are limited to a specified healthcare field and most of the licenses are exclusive in that field. For these rights, PSC paid us a one-time initial fee, issued us shares in PSC and has an ongoing royalty obligation. PSC has also agreed to cross-license any patents issued to PSC. We retain all rights to our technology outside of the specified healthcare field.
Dr. Michael M. Merzenich, who is one of our founders, directors, significant stockholders and a former officer of ours, is also a founder, director, significant stockholder and officer of PSC.
Seasonality
Our quarterly booked sales and revenue fluctuate seasonally, reflecting a number of factors including school purchasing practices, budget cycles and instructional periods. Historically, our booked sales have been lowest in the first quarter of the year and highest in the second quarter of the year.
Backlog
Our deferred revenue was approximately $23.0 million as of December 31, 2007, and $19.2 million as of December 31, 2006. These deferred revenues are primarily composed of the portion of multi-year sales, term-based sales, support and Progress Tracker sales not yet recognized as revenue, and professional development and technical services that have not yet been performed. Approximately $17.4 million of our deferred revenue as of December 31, 2007 is expected to be recognized within the next 12 months.
Employees
As of December 31, 2007 we had 215 full-time equivalent employees, compared to 197 at December 31, 2006. None of our employees is represented by a union or subject to collective bargaining agreements.
Page
ITEM 1A.
ITEM 1A.
RISK FACTORS
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 our K-12 market, so in order to grow our revenue and profit, we need to increase our reach 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 develop the brain to process more efficiently, are based on neuroscience research and focus on building 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 at least 30 minutes per day 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 revenue.
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 reach a broader group of 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.
We encourage our customers to purchase significant levels of on-site 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 revenue and growth prospects could be materially and adversely impacted and our profit could decline.
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 profitability.
Like other companies in the instructional market, our 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, 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 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 lost opportunities that can materially and adversely impact our revenue and profit.
Page
It is difficult to accurately forecast our future financial results. 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 revenue and net income or loss are difficult to predict and may fluctuate substantially from quarter to quarter and from year to year. We started operations in February 1996 and through 2002 incurred significant operating losses. In both 2006 and 2007, we had an operating loss and modest net income. At December 31, 2007, we had an accumulated deficit of $76.7 million from inception.
A significant proportion of our customers’ purchases are made within the last two weeks of each quarter. We therefore have limited visibility on revenue 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 shortfall that cannot be made up in the quarter. The effect of the concentration of sales at the end of the quarter is compounded by the fact that our various license and service packages have substantially differing revenue recognition periods. Even when the amount and timing of a transaction can be accurately projected, it may be difficult to predict which license package a customer will purchase.
In addition, our sales strategy emphasizes 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 revenue 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 revenue 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.
We may not achieve the benefits we expect from our acquisition of the Reading Assistant product, which could have a material adverse effect on our business, financial and operating results.
Our goals in acquiring the Reading Assistant product are to provide additional products to serve a broader range of students, to broaden our offering for English language learners for the US K-12 market as well as the international market, and to further leverage our growing direct sales organization with additional complementary and effective products for sale. To fully realize the anticipated benefits from the acquisition, we will face a number of post-transaction challenges:
•
We must significantly increase the volume of sales over the level historically achieved by Soliloquy. In addition, if our understanding about the Reading Assistant product, its ease of use, efficacy, and acceptability to educators is not correct, it will be more challenging to reach our expected sales volume.
•
We must successfully retain critical management and technical personnel who have joined us from the Soliloquy business.
•
We may experience unanticipated difficulties in further developing the Reading Assistant product. If so, development of product improvements and new products built on the Reading Assistant platform may be more costly and may take more time than we expect.
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 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:
Page
•
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 us or our 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.
If our products contain errors or if customer access to our web-delivered products is disrupted, we could lose new sales and be subject to significant liability claims.
Because our software products are complex, they may contain undetected errors or defects, known as bugs. Bugs can be detected at any point in a product’s life cycle, but are more common when a new product is introduced or when new versions are released. In the past, we have encountered unexpected bugs in our products shortly after release. We expect that, despite our testing, errors will be found in new products and product enhancements in the future. Significant errors in our products could lead to:
•
delays in or loss of market acceptance of our products;
•
diversion of our resources;
•
a lower rate of expansion purchases from current customers;
•
injury to our reputation; and
•
increased service expenses or payment of damages.
Our Progress Tracker data tool and the Web-enabled version of the Reading Assistant product both rely on the World Wide Web in order to function. Unanticipated problems affecting our network systems could cause interruptions or delays in the delivery of that product. The servers that support Progress Tracker are currently located in a third-party co-location facility in Sacramento, California. While we believe that the services provided by this facility are robust, interruptions in customer access could be caused by the occurrence of a natural disaster, power loss, vandalism or other telecommunications problems. We have experienced problems due to power loss in the past, and we will continue to be exposed to the risk of access failure in the future.
If our products do not work properly, or if there are problems with customer access to Progress Tracker or the Web-enabled version of Reading Assistant, we may be required to issue credits, customers may elect not to renew their support or access contracts or not to purchase additional licenses, we may lose sales to potential customers and we may be subject to liability claims. We cannot be certain that the limitations of liability set forth in our agreements would be enforceable or would otherwise protect us from liability for damages. A material liability claim against us, regardless of its merit or its outcome, could result in substantial costs, significantly harm our business reputation and divert management’s attention from our operations.
We will be required to comply with the auditors’ attestation requirement of Sarbanes-Oxley Section 404 starting in fiscal 2008 or fiscal 2009. If we or our auditors determine that our internal controls over financial reporting are not effective or if we are unable to comply with the auditors’ attestation requirement when we are required to do so, such ineffective controls or non-compliance could have a materially adverse effect on us.
Page
Under Sarbanes-Oxley Section 404, as implemented by the SEC and PCAOB, we were required to provide an initial management assessment on our internal control over financial reporting for fiscal 2007 and we have complied with that requirement in this Form 10-K.
Under current rules, we will be required to provide an auditors’ attestation on our internal controls for fiscal 2008. However, the SEC has recently proposed extending the deadline for that requirement so that, as long as we are a non-accelerated filer measured at June 30, 2008, we would not be required to comply with the auditor’s attestation requirement until fiscal 2009. We cannot assure you that, in the course of completing the work to satisfy the auditors’ attestation requirement, we or our auditors will not detect a material weakness in our internal control over financial reporting or that we can satisfactorily comply with the attestation requirement.
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.
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 net income.
United States 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 are struggling academically. Federal funds typically are restricted to specified uses.
We believe that the funding for a substantial portion of our K-12 sales comes from federal funding, in particular IDEA (special education) and Title One 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 have a materially adverse impact on our revenue.
State and local school funding can be significantly impacted by fluctuations in tax revenues due to changing economic conditions. States are forecasting shortfalls in their tax revenues for fiscal 2009, because of the existing housing slump and a potential recession in the nationwide economy. While education spending remains an important priority for states, it faces competition from demands for relief for homeowners, transportation spending and rising health care costs. An economic downturn leading to a significant reduction in state tax revenues could have a materially adverse impact on our revenue.
The availability of funding for instructional products like ours can also be affected by unpredictable events, such as increases in energy costs or damage due to severe weather. We believe that severe storms and spiking energy costs adversely impacted our sales in 2005. Unpredictable events of similar magnitude could adversely impact our revenue in the future.
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 improving brain processing efficiency and developing 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 we are, are more established in the school market than we are, offer a broader range
Page
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.
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 our 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.
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 2008 and the next several years. In 2007 and 2006, we generated $6.1 million and $4.3 million, respectively, in cash from operating activities. We ended 2007 with $21.2 million in cash and cash equivalents. We expended $10.7 million in cash in connection with the acquisition of the Reading Assistant product line.
In addition, we have a line of credit with Comerica Bank totaling $5.0 million, which expires on December 30, 2008. At December 31, 2007 no borrowings were outstanding and we were in compliance with the covenants of that line.
Funding our liquidity needs out of cash flow from operations will require us to achieve certain levels of booked sales and expenses. 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 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.
If we are unable to maintain our access to the intellectual property rights that we license from third parties, our sales and net income will be materially and adversely affected.
Our most important products are based on licensed inventions owned by the University of California and Rutgers, the State University of New Jersey. In 2007, we generated approximately 78% of our booked sales from products that use this licensed technology. If we were to lose our rights under these licenses (whether through expiration of our exclusive license period, expiration of the underlying patent’s exclusivity, invalidity or unenforceability of the underlying patents, a breach by us of the terms of the license agreements or otherwise), such a loss of these licensed rights or a requirement that we must re-negotiate these licenses could materially harm our booked sales, our revenue and our net income.
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. Issued patents can prove to be invalid or unenforceable as a result of a variety of reasons, including deficiencies in prosecution. As a result of potential deficiencies during the prosecution of certain patents to which we have rights, it is possible that these patents may be subject to a claim of unenforceability or invalidity. If others are able to develop similar products due to the expiration, unenforceability or invalidity of the underlying patents, the resulting competition could materially harm our booked sales, revenue and net income. The Company
Page
historically has not registered its copyrights in the United States, which may make it difficult to collect damages from a third party that may be infringing a Company copyright. The degree of future protection for our proprietary rights is also uncertain for products or product improvements in early-stage development, because it is difficult to predict from early-stage development efforts which product(s) will ultimately be marketed or what form the ultimately marketed product(s) will take.
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, and the outcome of any such proceedings cannot be accurately predicted. 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. In addition, competitors may design around our technology or develop competing technologies. Intellectual property rights may also be unavailable or limited in some foreign countries, which could make it easier for competitors to capture or increase their market share with respect to related technologies.
We generally require the execution of a written licensing agreement, which restricts the use and copying of our software products. However, if unauthorized copying or misuse were to occur to a substantial degree, our sales could be adversely affected.
Our common stock is thinly traded and its price is volatile.
Our common stock presently trades on the Nasdaq Global Market, and our trading volume is low. For example, for the last three months of 2007, our average daily trading volume was approximately 43,000 shares. The market price of our common stock has been highly volatile since we became publicly traded and could continue to be subject to wide fluctuations.
The ownership of our common stock is concentrated.
At December 31, 2007, Trigran Investments owned approximately 24% of our outstanding stock, and our executive officers and directors held approximately 15% 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.
ITEM 1B.
ITEM 1B.
UNRESOLVED STAFF COMMENTS
Not applicable
ITEM 2.
ITEM 2.
PROPERTIES
We lease approximately 30,500 square feet of office space in Oakland, California for our headquarters under a lease that expires in December 2013. The lease includes two five-year options to extend the term of the lease. We also lease approximately 2,500 square feet of office space in Tucson, Arizona for our support center under a lease that expires in 2009. In early 2008, we entered into a new lease for our Reading Assistant operations in Waltham, Massachusetts for approximately 6,000 square feet that expires in September 2011. We are currently evaluating our space requirements in Tucson, Arizona and may lease additional space in that area. We believe our other facilities are sufficient for our operations currently and should be adequate to meet our needs for at least the next two years.
ITEM 3.
ITEM 3.
LEGAL PROCEEDINGS
Litigation with Former Sales Representative
On January 23, 2008, Robert G. (Jerry) Smith, a former account manager in Florida, filed a complaint against us in US District Court for the Middle District of Florida. The lawsuit claims breach of contract for unpaid wages of approximately $423,000. Smith alleges that he is owed additional commission relating to large sale transaction in the second quarter of 2007. We are in the early stages of this proceeding. Discovery has not yet started.
Page
Litigation with School District Customer
On October 22, 2007, we were sued by the Christina School District (the “District”) in the US District Court for the District of Delaware. The District had previously been sued by investors who are the assignees of the lessor under a Master Lease Purchase Agreement (the “Lease Agreement”) entered into by the District in 2003. The District ceased making payments under the Lease Agreement and the investors have claimed that the District breached the Lease Agreement. The District filed a third party complaint against us, claiming that we must refund amounts paid to us by the District for training and consulting under our contracts with the District. Because the District decided not to use our products, it did not therefore use all of the services specified in the contract. The third party complaint alleges unjust enrichment against us. The District states that the amount it is seeking is approximately $220,000. We have filed a motion to dismiss the complaint, which has not yet been decided.
We believe that these claims are not meritorious and that we do not have any significant liability to these claimants.. We therefore do not believe that the resolution of these matters will have a material adverse effect on our financial position or results of operations.
ITEM
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
Page
EXECUTIVE OFFICERS
The following table sets forth various information concerning our executive officers, as of March 10, 2008:
NAME
AGE
POSITION
Robert C. Bowen
Chairman and Chief Executive Officer
D. Andrew Myers
President and Chief Operating Officer
Linda L. Carloni
Vice President, General Counsel and Corporate Secretary
Glenn G. Chapin
Vice President, Sales
Jane A. Freeman
Executive Vice President, Chief Financial Officer, and Treasurer
Dr. William M. Jenkins
Sr. Vice President, Product Development
Jessica Lindl
Vice President, Marketing
Gillian A. McCormack
Vice President, Operations
Robert C. Bowen joined us as Chairman and Chief Executive Officer in June 2002. From 1989 to 2001, he served as a senior executive and officer of National Computer Systems, a provider of educational assessment and administrative software and services. His last assignment there, from 1995 to 2001, was as President of NCS Education, a leading provider of enterprise software for K-12 school districts. NCS was acquired by Pearson, PLC, in 2000. After retiring from NCS in 2001, Mr. Bowen consulted for various businesses in education until joining us. Previously, Mr. Bowen held senior executive positions with other leading education and publishing companies, including seventeen years with McGraw-Hill. Early in his career, Mr. Bowen was a high school math teacher, a coach, and a school district administrator. Mr. Bowen received his bachelor’s and master’s degrees from the University of Tennessee, Chattanooga.
D. Andrew Myers joined us as President and Chief Operating Officer in January 2008. Prior to joining us, Mr. Myers worked at Pearson Education since 1997. His last position was as Senior Vice President, Digital Product Development for Pearson Curriculum, where he was responsible for integrating the technology teams from six preceding business units into a digital development group of 275 employees. From August 2004 to March 2007, Mr. Myers was the Chief Operations Officer for Pearson Digital Learning, where he was responsible for setting product, financial, technical and operational strategies for that 580-employee business unit. From 2002 to 2004, Mr. Myers served as Vice President Sales for Pearson Digital Learning. Mr. Myers started with Pearson as a sales representative in 1996. Pearson Education is the education division of Pearson PLC, an international media company. Mr. Myers holds an MBA from the Haas School of Business at the University of California Berkeley and a BA in finance from the University of Utah.
Linda L. Carloni joined the Company as General Counsel in October 1999, became our Secretary in March 2000 and was appointed Vice President in June 2000. Before joining us, Ms. Carloni was a founder and Vice President of Alere Medical Incorporated, a healthcare services start-up. Earlier in her career, Ms. Carloni worked in technology transfer for the University of California, was the general counsel of Nellcor Incorporated, a medical device company, and was an associate and a partner at the Cooley Godward law firm. She received her bachelor’s degree in political science from Case Western Reserve University and her law degree from Boalt Hall School of Law at the University of California, Berkeley.
Glenn G. Chapin joined the Company in April 2001 as Vice President of K-12 Sales. Mr. Chapin brings to his role with us more than 25 years experience working with schools to implement technology based curriculum and management systems that impact teaching and student learning. From 1995 to 2001, Mr. Chapin held sales executive positions at CompassLearning, completing his service there as the Southern Region Vice President. Prior to his post at CompassLearning, Mr. Chapin held sales executive positions at National Computer Systems, where he held positions of increasing responsibility over a 15 year period, from serving as the Midwest territory sales representative and rising
Page
to Southern Region Sales VP prior to his departure. Mr. Chapin is a graduate of St. John Fischer College in Rochester, New York where he received his Bachelor of Science degree in Business Administration.
Jane A. Freeman joined us as Vice President, Finance and Treasurer in August 1999 and was named Chief Financial Officer in January 2000. She was appointed Senior Vice President in January 2004 and Executive Vice President in December 2007. She also served as our Vice President Business Development from August 1999 until June 2000. Prior to joining us, Ms. Freeman spent 20 years in the investment business. From 1988 through 1998, she was employed by Rockefeller & Co., a global investment firm, where she led the global asset allocation process, managed the US Small Cap equity product and served on the Management Committee of the firm. She is a director of four mutual funds managed by Harding Loevner LLP. Ms. Freeman holds a B.A. in mathematics and chemistry and an M.B.A. (with distinction) from Cornell University and a License in Applied Economics from the University of Louvain in Belgium.
Dr. William M. Jenkins was appointed Senior Vice President, Product Development in November 2000. Dr. Jenkins is a founder and served as our Vice President, Product Development from June 1997 until November 2000. From March 1996 to June 1997, Dr. Jenkins was our Vice President, Research and Development. From 1990 to 1996, Dr. Jenkins was an Adjunct Associate Professor at the University of California, San Francisco. Dr. Jenkins is the principal developer of our current software products. Dr. Jenkins holds a B.S. in Psychology, an M.A. in Psychobiology and a Ph.D. in Psychobiology from Florida State University, with additional post-doctoral training from UCSF.
Jessica Lindl joined us as Vice President of Marketing in March 2007. Prior to joining us, Ms. Lindl served as Vice President of Marketing and Product Management for Riverdeep, a leading developer of educational software. Ms. Lindl held marketing management positions of increasing responsibility at Riverdeep and The Learning Company, which was acquired by Riverdeep, from 2001 through 2006. Prior to her tenure at Riverdeep, Ms. Lindl served as the Director of Product Management for Simplexis, an e-procurement provider for the K-12 market, in 2000 and 2001 and as part of the sales management team for AT&T in San Francisco from 1995 to 1998. Ms. Lindl holds a bachelor’s degree in economics and international studies from Miami University in Oxford, Ohio and an MBA from the Haas School of Business at the University of California, Berkeley.
Gillian A. McCormack joined us as Vice President, Operations in October 2002. Prior to joining us, Ms. McCormack had served as vice president of professional and technical services for NCS Learn (Pearson Education) beginning in 2000. From 1994 through 2000, she was the vice president of customer support for NovaNET, an E-learning company. Earlier in her career, Ms. McCormack worked in management and field positions at Jostens Learning, an educational software company. Ms. McCormack began her career as an elementary and middle school teacher and was a master of teacher training in Tucson, Arizona. She holds a bachelor of science in elementary education and a bachelor of science in special education and learning disabled K-12 from the University of Arizona.
Page
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
(a) Market Information. Our common stock currently is, and during all of 2006 and 2007 was, traded on the NASDAQ Global Market under the symbol “SCIL”. (In 2006, the name of the market was changed from the NASDAQ National Market to the NASDAQ Global Market.)
The following table sets forth, for the periods indicated, the closing high and low sales prices per share of our common stock as reported on the NASDAQ Global Market.
Holders. As of January 31, 2008, the approximate number of stockholders of record of our common stock was 112.
Dividend Policy. We have never declared or paid cash dividends on our common stock, and we do not anticipate paying any cash dividends in the foreseeable future. Our current Loan and Security Agreement with Comerica Bank provides that we may not pay any dividends other than stock dividends during the term of the Agreement.
Securities Authorized for Issuance under Equity Compensation Plans. For information regarding securities authorized for issuance under equity compensation plans, see Item 12.
Performance Measurement Comparison.
The following chart compares the cumulative total stockholder return of Scientific Learning Common Stock for the five years ended December 31, 2007 with the cumulative total return during the same period of (i) the NASDAQ Composite Market Index and (ii) a Scientific Learning constructed peer group index. The companies in the peer group index were selected on the basis of similarity in the nature of their business. At December 31, 2007, the peer group included Plato Learning, Inc., Princeton Review, Renaissance Learning Inc., and Scholastic Corporation.
Over the last five years, the peer group has changed from time to time because of acquisitions, changes in business, and other changes affecting peer group companies. This table shows these changes:
Members of Peer Group
Tenure in Peer Group
Excelligence
Removed from peer group after September 30, 2006 after it stopped trading.
Lightspan, Inc.
Removed from peer group during 2003 upon its acquisition
Riverdeep
Removed from peer group during 2002 because its stock was moved from the Nasdaq to the Irish Stock Exchange
Smart Force
Removed from peer group during 2002 upon its acquisition
Student Advantage
Removed from peer group during 2002 when in the process of negotiating its sale
Sylvan Learning Systems, Inc.
Removed from peer group during 2003 because it changed the nature of its business.
Page
The comparison assumes $100 was invested on December 31, 2002 in Scientific Learning Common Stock and in each of the foregoing indices. It also assumes reinvestment of dividends. The stock price performance shown in the graph below should not be considered indicative of potential future stock price performance.
Recent Sales of Unregistered Securities; Use of Proceeds from Registered Securities. Not applicable
(b) Not applicable
(c) Not applicable
Page
ITEM 6.
ITEM 6.
SELECTED FINANCIAL DATA
In thousands, except per share amounts
(1)
We have paid no cash dividends since our inception.
Page
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS
Overview
We develop and distribute the Fast ForWord family of software. Our patented products build learning capacity by rigorously and systematically applying neuroscience-based learning principles to improve the fundamental cognitive skills required to read and learn. Extensive outcomes research by independent researchers, our founding scientists, school districts and our company demonstrates the rapid and lasting gains achieved through Fast ForWord participation. Our products are marketed primarily to K-12 schools in the US, to whom we sell through a direct sales force. 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. Since our inception, learners have used our Fast ForWord products over one million times and approximately 5,200 schools have purchased at least $10,000 of our Fast ForWord product licenses and services. As of December 31, 2007 we had 215 full-time equivalent employees, compared to 197 at December 31, 2006.
On January 7, 2008, we completed the acquisition of substantially all of the assets of Soliloquy Learning, including the Reading Assistant product, for $10.7 million in cash. The Scientific Learning Reading Assistant combines advanced speech recognition technology with scientifically based courseware to help students strengthen fluency, vocabulary and comprehension to become proficient life-long readers.
Business Highlights
We market our Fast ForWord products primarily as a reading intervention solution for struggling, at-risk, English Language Learners, and special education students. Approximately 70% of the estimated 55 million public and private school K-12 students in the United States test as not proficient in reading. While our installed base is growing, the approximately 5,200 schools that have purchased at least $10,000 of our product licenses and services represent a small fraction of the approximately 125,000 K-12 schools in the US.
Federal education funds are a critical resource in helping school districts address the needs of the most challenged learners. We believe that a significant proportion of our sales are funded by federal sources, particularly Title One and IDEA (special education) grants. In fiscal 2008, these programs are projected to total $25.4 billion. States are forecasting shortfalls in their taxation revenues for fiscal 2009 because of the existing housing slump and a potential recession in the nationwide economy. Such shortfalls would have an impact on education spending, although it is likely that education would remain among the top priorities.
Sales of our products are included in the growing supplemental education materials segment of the overall education materials market. Simba Information’s Publishing for the PreK-12 Market 2007 - 2008 (April 2007) estimates that:
Ø
The total market for K-12 instructional materials is $8.58 billion, growing at 4.2%
Ø
The supplemental materials segment of that market is $4.29 billion
Ø
The fastest growing supplemental market, technology based electronic courseware, is $856 million and expected to grow 9.4%
Company Highlights
In 2007 total revenue increased by 12% compared to 2006. This compares to an increase of 2% in 2006 compared to 2005. We attribute our revenue increase primarily to:
•
Our improved sales capacity resulting from additional sales representatives hired in 2006 who became productive in 2007.
•
A continued focus within our sales organization on quickly closing transactions over $100,000, and on increasing the size of these transactions.
Booked sales increased 16% in 2007 compared to 2006. Revenue increased at a slower rate than booked sales because in 2007 our sales mix contained a greater proportion of multiple year service and support offerings, where a significant amount of revenue is to be recognized in future periods, as compared to previous years. (For more explanation of booked sales, see Booked Sales and Selling Activity, below.)
We also experienced continued growth in our international sales, which increased 62% in 2007 compared to 2006, following an increase of 112% in 2006 compared to 2005. In 2007, international sales comprised approximately 2%
Page
of total sales, compared to 1.5% in 2006. We conduct our international business through value-added representatives (“VARs”). At December 31, 2007 we had 24 VARs selling in 42 countries.
We reported net income of $1.2 million in 2007, compared to net income of $0.2 million in 2006. The increase in net income is primarily due to an income tax benefit of approximately $1.2 million arising from the reduction of a portion of our deferred taxation valuation allowance.
During 2007 we introduced our Reading Progress Indicator service. While we are pleased with the initial results, the incremental revenue from this additional offering was not significant in 2007.
We ended 2007 with $21.2 million in cash and cash equivalents, and had no outstanding debt. We did not make use of our credit line during 2007. Net cash generated from operating activities was $6.1 million.
In January 2008 we completed the acquisition of the Soliloquy Reading Assistant product line and substantially all of the other assets of the Soliloquy Learning business, based in Waltham, Massachusetts, for cash consideration of $10.7 million. We estimate that as a direct result of this acquisition our revenue and our operating expenses in 2008 will increase.
Results of Operations
Revenues
2007 revenue compared to 2006: Product revenues, which comprise the majority of our revenue, increased modestly in 2007 compared to 2006. The growth in product revenues was slower than total revenues due to lower than expected product sales, and an increase in multiple year service and support packages which include a lower proportion of product revenue. In 2007 one customer accounted for more than 10% of our total revenue. On average 48% of booked sales in 2007 were recognized into revenue in the quarter in which the sale occurred.
Our service and support revenue increased significantly in 2007 compared to 2006 due to more services delivered and a higher number of schools on support. At December 31, 2007 we had approximately 32% more schools on support than at December 31, 2006. The increase in schools on support is mainly due to our success in selling renewals to our growing installed base.
2006 revenue compared to 2005: Product revenue declined in 2006 compared to 2005 because we recognized approximately $6.5 million less revenue from sales made in prior periods. This decrease was almost offset by increased revenue recognized on sales booked in 2006. On average 52% of booked sales in 2006 were recognized into revenue in the quarter in which the sale occurred.
Service and support revenue increased in 2006 by 10%, primarily due to stronger sales of on-site services, partially offset by a lower level of revenue recognized from sales made in prior years. Service and support revenue also reflected the increase in the number of schools purchasing ongoing Progress Tracker access and support contracts. We had 26% more customers on support at December 31, 2006 than at December 31, 2005.
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. Revenue on a GAAP basis is recorded for booked sales when all four of the requirements for revenue recognition have been met; if any of the requirements to recognize revenue are not met, the sale is booked to deferred revenue. 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 revenue, and is not intended to represent a substitute measure of revenue or any other performance measure calculated under GAAP.
Page
The following reconciliation table sets forth our booked sales, revenues and change in deferred revenue for the twelve months ended December 31, 2007, 2006 and 2005:
Booked sales in the K-12 sector, which accounted for over 91% of booked sales in 2007, increased 14% to $45.6 million compared to $40.2 million in 2006. Booked sales in the K-12 sector were $28.4 million in 2005.
We believe that the principal reasons for the increase in 2007 booked sales are:
•
Our improved sales capacity resulting from additional sales representatives hired in 2006 who became productive in 2007. We had an average of 49 quota bearing sales representatives in 2007, compared to 42 in 2006.
•
A continued focus within our sales organization on quickly closing transactions over $100,000, and on increasing the size of these transactions. Our 2007 sales included one transaction for approximately $7.4 million.
The increase in booked sales in 2007 was smaller than the increase that we experienced in 2006. The large increase in 2006 was mainly because sales in 2005 in several key states had been depressed due to severe weather conditions, spiking energy prices, and other factors that contributed to general funding uncertainty.
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. In 2007 we continued to focus our sales force on multi-site sales, and we closed 90 transactions in excess of $100,000 compared to 102 in 2006 and 59 in 2005. Although we closed fewer large deals in 2007 than in 2006, the average size of these transactions increased substantially, from approximately $285,000 in 2006 to approximately $349,000 in 2007. The increase in average transaction size was mainly due to the impact of one transaction for approximately $7.4 million. For the year ended December 31, 2007, 69% of our K-12 booked sales were realized from sales over $100,000. For the comparable periods ending December 31, 2006 and 2005, large booked sales accounted for 67% and 59% of booked sales respectively.
Large booked sales include volume discounts but the percentage discount applicable to any given transaction will vary and the relative percentage of large sales and smaller 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, number and timing of large transactions in the future.
Booked sales outside the K-12 market (primarily to the adult corrections market, private practice clinicians and international customers) increased by 40% in 2007 compared to 2006, mainly due to the impact of a large corrections sale. International sales increased by 62% in 2007 compared to 2006. Non K-12 sales in 2006 were flat relative to 2005.
Although federal, state and local budget pressures make for an uncertain funding environment for our customers, we are 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. For a discussion of some of the other important factors that affect our results, see Risk Factors. 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
Page
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.
Gross Profit and Cost of Revenues
The overall gross profit margin improved slightly in 2007 compared to 2006. The increase in gross margin was driven primarily by increased service and support margins, partially offset by a reduction in the proportion of higher margin product revenue. Service and support revenue growth of 36%, combined with an 8% increase in service and support costs, resulted in an increase in the service and support gross margin from 28% to 43%. The main reasons for the increase in service and support gross margin were higher staff utilization and leverage from our new Tucson support center. Higher margin product revenues comprised 67% of total revenues in 2007 compared to 73% in 2006.
The overall gross profit margin declined in 2006 compared to 2005, as a small improvement in product margin was more than offset by a substantial decrease in services and support margin. Product margins improved primarily because capitalized software amortization, which was charged to product cost of revenue, ceased in June 2006. We also reduced costs by limiting the quantity of electronic media that we send to customers. Service and support margins declined from 2005 to 2006 primarily due to our investment in a new support center in Tucson, Arizona, which replaced an outside vendor. We also hired additional service staff in anticipation of increased service sales.
Operating Expenses
Sales and Marketing: Sales and marketing expenses consist principally of salaries and incentive compensation paid to employees engaged in sales and marketing activities, travel costs, tradeshows, conferences, and marketing and promotional materials. The increase in sales and marketing costs in 2007 compared to 2006 is mostly due to higher employee costs, as headcount has increased by 11% year over year, and also to increased spending on marketing initiatives such as trade shows and the use of marketing consultants, partially offset by reduced incentive compensation costs. In 2006, our sales and marketing expenses increased over 2005, primarily due to increased sales and marketing staff, more marketing activities and higher commissions reflecting higher booked sales. Commissions in 2006 were $1.3 million higher than in 2005. At December 31, 2007, we had 51 field-based quota-bearing sales personnel selling to public schools, compared to 44 and 36 at December 31, 2006 and 2005 respectively. We expect our sales and marketing expenses to increase at a low double digit rate in 2008.
Research and Development: 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. The increased costs for 2007 compared to 2006 are primarily due to higher outsourced development costs. Research and development expenses increased by 6% in 2006 due primarily to stock compensation expenses and patent acquisition legal fees. We expect research and development expenses to almost double in 2008 due to the addition of the Reading Assistant employees and the amortization of the acquired intangible assets.
Page
General and Administrative: General and administrative expenses principally consist of salaries and compensation paid to our executives, accounting staff and other support personnel, as well as travel expenses for these employees, and outside legal and accounting fees. The increase in 2007 expenses compared to 2006 is mostly due to the legal, accounting, printing and travel costs of approximately $688,000 related to our secondary stock offering. Stock compensation expense was also higher in 2007 than in 2006. These costs were partially offset by lower expenses for management incentive compensation. General and administrative expenses increased by 14% in 2006 due primarily to stock compensation expenses and incentive compensation expenses, partially offset by a reduction in accounting and legal fees relating to the restatement of financial results that were expensed in 2005. Accounting and legal fees associated with the restatement that were expensed in 2005 totaled approximately $380,000. We expect general and administrative expenses to increase modestly in 2008.
Other Income from Related Party
In September 2003, we signed an agreement with Posit Science Corporation (“PSC”), transferring our patented technology to PSC for use in the health field. During the twelve months ended December 31, 2007, 2006 and 2005 we recorded $247,000, $150,000, and $50,000 respectively, for royalties received and services provided to PSC. 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.
Interest and Other Income (Expense), net
In 2007, interest and other income (expense), net, consisted primarily of interest earned on our invested cash of $680,000 and a reclassification of $332,000 of service and support revenue relating to two customers for whom we are no longer performing services. For 2006, interest and other income (expense), net, consisted primarily of interest earned of $494,000 and a reclassification of $143,000 of service and support revenue relating to the same two customers. In 2005, interest and other income (expense), net, comprised mainly interest earned on our invested cash of $242,000 and interest on officer loans of $170,000. All officer loans were repaid in full by March 31, 2006.
Income Tax Provision (Benefit)
During the fourth quarter of 2007, we recorded an income tax benefit of approximately $1.1 million. This benefit included a $1.2 million reduction in our deferred tax asset valuation allowance related to a portion of our deferred tax assets that will more likely than not be realized, based on future projected taxable income for fiscal 2008. Prior to the fourth quarter of 2007, we recorded a full valuation allowance against our deferred tax assets. These projections were based on one year of projected future taxable income.
As of December 31, 2007, we have U.S. federal and state net operating loss carryforwards of approximately $61.2 million and $46.5 million, respectively. The U.S. federal net operating loss carryforwards will expire at various dates beginning in 2018 through 2027 if not utilized. State net operating loss carryforwards will expire at various dates beginning in 2012 through 2017.
As of December 31, 2007, we had U.S. federal and state tax credit carryforwards of approximately $1.2 million and $0.9 million, respectively. The federal credit will expire at various dates beginning in 2011 through 2027, if not utilized. California state research and development credits can be carried forward indefinitely.
Net operating loss carryforwards and credit carryforwards reflected above are limited due to ownership changes as provided in the Internal Revenue Code and similar state provisions.
Page
Liquidity and Capital Resources
Our cash and cash equivalents and short-term investments were $21.2 million at December 31, 2007 compared to $16.4 million at December 31, 2006 and $12.1 million at December 31, 2005. At December 31, 2007 there were no borrowings outstanding under our credit line. In January 2008 we expended $9.7 million of our cash for the acquisition of the assets of Soliloquy Learning.
Net cash provided by operations in 2007 was $6.1 million, compared to cash provided by operations of $4.3 million in 2006 and $2.1 million used in operations in 2005. Overall, our receivable collection experience has remained strong throughout 2007. We collected $51.7 million of receivables in 2007, compared to $40.3 million of receivables in 2006 and $34.1 million in 2005.
Net cash used in investing activities in 2007 was $2.4 million, consisting of net purchases of property and equipment of $1.1 million, a loan to JTT Holdings of $1.0 million in connection with the January 2008 acquisition of Soliloquy Learning, and acquisition costs incurred of $319,000.
During the year ended December 31, 2006, we purchased an enterprise-wide customer relationship management system. As of December 31, 2007 and 2006, a net book value of $1.4 million and $463,000, respectively, related to the purchase and subsequent implementation of this system was included in property and equipment. These costs will be depreciated over the initial estimated useful life of five years.
Net cash generated by investing activities in 2006 was $2.4 million, consisting of the maturity of short-term investments of $3.0 million and officer loan repayments of $0.2 million, partially offset by property and equipment purchases of $0.8 million.
Net cash generated by investing activities in 2005 was $0.4 million, consisting of the purchase of $3.0 million of short-term investments and the purchase of hardware and software for $0.2 million, which were more than offset by the repayment of $3.6 million of officer loans.
Net cash generated by financing activities in 2007, 2006 and 2005 was $1.2 million, $0.6 million, and $0.5 million respectively. Net cash generated by financing activities in all three years resulted from the sale of stock upon option exercises and through purchases of stock through the employee stock purchase plan. There was no borrowing on our credit line in 2007 or 2006.
Because our booked sales tend to be seasonal, we may have negative cash flows in particular quarters, particularly the first quarter, when booked sales tend to be substantially lower than in other quarters.
On June 5, 2007 we amended our existing revolving line of credit agreement with Comerica Bank. The maximum that can be borrowed under the agreement is $5.0 million. The line expires on December 2, 2008. Borrowing under the line of credit bears interest at a floating prime rate, or a fixed rate of LIBOR plus 2.5%. To secure the line we granted Comerica a security interest in all of our assets other than our intellectual property. We also agreed with Comerica that we will not grant a security interest in our intellectual property to any third party. Borrowings under the line are subject to various covenants. The agreement includes a letter of credit sublimit not to exceed $1.0 million. At December 31, 2007, we have an outstanding letter of credit for $206,000. There were no borrowings outstanding on the line of credit at December 31, 2007 and we were in compliance with all our covenants.
We expect that cash flow from operations will continue to be our primary source of funds for the next several years. Again, this will require us to achieve certain levels of booked sales. If we are unable to achieve sufficient levels of 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 our 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.
Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements.
Page
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 expires in December 2013. We also have a lease agreement for our Tucson, Arizona office through April 2009 at an average rent of approximately $4,500 per month for the period subsequent to January 1, 2007. In early 2008, we entered into a new lease for our Reading Assistant operations in Waltham, Massachusetts for approximately 6,000 square feet that expires in September 2011. This lease, as well as the existing Waltham lease that expires on March 31, 2008, is included in the table under “operating lease obligations”.
We also make royalty payments to the institutions who participated in the original research that produced our initial products. Our minimum royalty payments are $150,000 per year.
The following table summarizes our obligations at December 31, 2007 and the effects such obligations are expected to have on our liquidity and cash flow in future periods.
Our purchase order commitments at December 31, 2007 are not material
Effective January 1, 2007, we adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109.” At December 31, 2007, we had a liability for unrecognized tax benefits and an accrual for the payment of related interest totaling $25,000, of which approximately $3,000 is expected to be paid within one year. For the remaining liability, due to the uncertainties related to these tax matters, we are unable to make a reasonably reliable estimate when cash settlement with a taxing authority will occur. Refer to Note 10 to the Financial Statements for additional discussion on unrecognized tax benefits.
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. In 2002 some of these officers left our Company. The notes were secured by shares of our Common Stock owned by the current and former officers. The loans bore interest at 4.94%. Principal and interest were due December 31, 2005. During the twelve months ended December 31, 2005 we received $3.6 million in loan repayments, including interest. At December 31, 2005 there was a remaining balance due of $297,000. This represented principal and interest from one of the former officers. During the first quarter of 2006 we received the balance due in the form of cash and stock.
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 and allowance for doubtful accounts 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.
Page
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 recognize revenue using the residual method, whereby the difference between the total arrangement fee and the total “vendor specific objective evidence”(“VSOE”) of fair value of the undelivered elements is recognized as revenue relating to the delivered elements. 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.
Multiple contracts with the same customer are generally accounted for as separate arrangements except in cases where contracts are so closely related that they are effectively part of a single arrangement.
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. We adjust this allowance periodically based on our historical experience of bad debt write offs, which have been low in recent years. Cancellations and refunds are allowed in limited circumstances, and such amounts have not been significant.
Page
Income Taxes
We account for income taxes using the liability method, which requires the recognition of deferred tax assets or liabilities for the tax-effected temporary differences between the financial reporting and tax bases of our assets and liabilities, and for net operating loss and tax credit carryforwards. Prior to the fourth quarter of 2007, we recorded a full valuation allowance to reserve for the benefit of our deferred tax assets due to the uncertainty surrounding our ability to realize these assets.
During the fourth quarter of 2007, we recorded an income tax benefit of $1.1 million. This benefit included a $1.2 million reduction in the valuation allowance related to a portion of our deferred tax assets that will more likely than not be realized. This determination was primarily based on projected taxable income. In evaluating our ability to realize our deferred tax assets we consider all available positive and negative evidence including our past operating results and our forecast of future taxable income. In determining future taxable income, we make assumptions to forecast federal and state operating income, the reversal of temporary differences, and the implementation of any feasible and prudent tax planning strategies. These assumptions require significant judgment regarding the forecasts of future taxable income, and are consistent with the forecasts used to manage our business. We intend to maintain the remaining valuation allowance until sufficient further positive evidence exists to support further reversals of the valuation allowance. Our income tax expense recorded in the future will be reduced to the extent of offsetting decreases in our valuation allowance.
Stock-Based Compensation
Under the fair value recognition provisions of SFAS No. 123R, we use 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 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.
The estimated expected stock price volatility decreased from 80% in 2006 to 49% in 2007. Our expected stock price volatility is based upon our historical experience over the expected life of the options, and this decrease occurred as a result of historical periods beyond the expected life of the options containing highly volatile prices being eliminated from the fiscal 2007 volatility calculation.
In the fourth quarter of 2007 we changed our estimate of the forfeiture rate from 11% to 3.5%, based on our experience of actual forfeiture rates. This resulted in incremental stock compensation expense of approximately $316,000 in the fourth quarter. Stock compensation expense may be adjusted in the future if actual forfeiture rates differ significantly from our current estimates.
ITEM 7A.
ITEM 7A.
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 that we earn on our cash and cash equivalents. We did not hold any marketable debt securities at December 31, 2007. A hypothetical increase or decrease in market interest rates by 10% from the market interest rates at December 31, 2007 would not have a material affect on our results of operations.
Page
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Report of Ernst & Young LLP, Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Scientific Learning Corporation
We have audited the accompanying balance sheets of Scientific Learning Corporation as of December 31, 2007 and 2006 and the related statements of income, stockholders equity (deficit), and cash flows for each of the three years in the period ended December 31, 2007. Our audits also included the financial statement schedule listed in the index at Item 15(a)(2). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Scientific Learning Corporation as of December 31, 2007 and 2006, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed in Notes 1 and 10 to the financial statements, Scientific Learning Corporation changed its method of accounting for share based payments as of January 1, 2006 and its method of accounting for uncertain tax positions as of January 1, 2007.
/s/ ERNST & YOUNG LLP
San Francisco, California
March 10, 2008
Page
Scientific Learning Corporation
Balance Sheets
(In thousands, except share and per share amounts)
See accompanying notes.
Page
Scientific Learning Corporation
Statements of Income
(In thousands, except per share amounts)
See accompanying notes.
Page
Scientific Learning Corporation
Statements of Cash Flows
(In thousands)
See accompanying notes
Page
Scientific Learning Corporation
Statements of Stockholders’ Equity (Deficit)
(In thousands, except share amounts)
See accompanying notes
Page
Notes to Financial Statements
1. Summary of Significant Accounting Policies
Description of Business
Scientific Learning Corporation develops and distributes the Fast ForWord family of software. Our patented products build learning capacity by rigorously and systematically applying neuroscience-based learning principles to improve the fundamental cognitive skills required to read and learn. 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. We sell primarily to K-12 schools in the United States through a direct sales force.
All of our activities are in one operating segment.
We were incorporated in 1995 in the State of California and were reincorporated in 1997 in the State of Delaware.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements as well as the reported amounts of revenues and expenses during the periods presented. Actual results may differ from those estimated.
Revenue Recognition
We derive revenue from the sale of licenses to our software and from service and support fees. Software license revenue is recognized in accordance with AICPA Statement of Position 97-2, “Software Revenue Recognition,” as amended by Statement of Position 98-9 (SOP 97-2). SOP 97-2 provides specific industry guidance and four basic criteria, which must be met to recognize revenue. These are: 1) persuasive evidence of an arrangement 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.
Booked 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 recognize revenue using the residual method, whereby the difference between the total arrangement fee and the total “vendor specific objective evidence” (“VSOE”) of fair value of the undelivered elements is recognized as revenue relating to the delivered elements. 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 of fair value 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. Direct costs related to deferred software license revenue are deferred until the related license revenue is recognized.
Multiple contracts with the same customer are generally accounted for as separate arrangements, except in cases where contracts are so closely related that they are effectively part of a single arrangement.
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 of fair value 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.
Page
Notes to Financial Statements
1.
Summary of Significant Accounting Policies (continued)
•
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 of fair value exists for all elements of an arrangement or all elements except software licenses, services revenue is recognized as performed. If VSOE of fair value 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. Our cash and cash equivalents consisted of the following (in thousands):
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.
Accounts Receivable
We conduct business primarily with public school districts and speech and language professionals in the United States. We maintain an allowance for doubtful accounts for estimated losses due to the inability of customers to make payments. We adjust this allowance periodically based on our historical experience of bad debt write offs.
Inventories
Product inventories, which are primarily finished goods, are stated at the lower of cost or market and are included in “Prepaid expenses and other current assets”. Cost is determined using a weighted average approach, which approximates the first-in first-out method. If inventory costs exceed expected market value due to obsolescence or lack of demand adjustments are recorded for the difference between the cost and the market value.
Fair Value of Financial Instruments
The carrying amounts of our cash and cash equivalents, short-term investments, accounts receivable, notes receivable from current and former officers, and accounts payable approximate fair value.
Page
Notes to Financial Statements
1. Summary of Significant Accounting Policies (continued)
Concentration of Risk
Financial instruments that potentially subject us to concentrations of credit risk consist principally of cash, cash equivalents, short-term investments and accounts receivable.
Cash and cash equivalents are invested in major financial institutions in the United States. Such deposits may be in excess of insured limits and are not insured in other jurisdictions. Management believes that the financial institutions that hold the Company’s investments are financially sound and, accordingly, minimal credit risk exists with respect to these investments.
Our accounts receivable are derived from booked sales to customers located primarily in the United States. We perform ongoing credit evaluations of our customers. We do not require collateral.
An allowance for doubtful accounts is determined with respect to those accounts that we have determined to be doubtful of collection. At December 31, 2007 one customer accounted for more than 10% of our accounts receivable. At December 31, 2006, no customer accounted for more than 10% of our accounts receivable. One customer accounted for more than 10% of our revenue in fiscal 2007. No customers accounted for more than 10% of our revenue in fiscal 2006 or 2005.
We have no off-balance sheet concentration of credit risk, such as foreign exchange contracts, option contracts or other hedging arrangements.
Our concentration of royalty arrangements potentially exposes us to risk. The patents and applications that we license are owned by the Regents of the University of California, and Rutgers, the State University of New Jersey, and relate to the basic speech and sound modification and adaptive technology developed at those institutions. In 2007, approximately 78% of our product booked sales was derived from selling products that use the licensed inventions.
Property and Equipment
Property and equipment are recorded at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, which range from three to five years.
Software Development Costs
We account for software development costs in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed,” under which certain software development costs incurred subsequent to the establishment of technological feasibility are capitalized and amortized over the estimated lives of the related products. Technological feasibility is established upon completion of a working model. In 2007, 2006 and 2005 costs incurred subsequent to the establishment of technological feasibility for new projects were not significant, and were charged to research and development expense. Software costs are amortized to cost of product revenues over the estimated useful life of the software, which is three years. Amortization was zero, $130,000, and $261,000 for the years ended December 31, 2007, 2006 and 2005, respectively. All capitalized software development costs were fully amortized by June 30, 2006.
Costs related to internally developed software and software purchased for internal use are capitalized in accordance with Statement of Position 98-1, “Accounting for Costs of Computer Software Developed or Obtained for Internal Use.” During the year ended December 31, 2006, we purchased an enterprise-wide, customer relationship management system. As of December 31, 2007, a net book value of $1.4 million related to the purchase and subsequent implementation of this system was included in property and equipment. These costs are being depreciated over the estimated useful life of five years.
Page
Notes to Financial Statements
1. Summary of Significant Accounting Policies (continued)
Long-Lived Assets
We regularly review the carrying value of long-lived assets. We continually make estimates regarding future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for these assets.
Accounting for Stock-Based Compensation
Effective January 1, 2006 we began recording compensation expense associated with stock-based awards and other forms of equity compensation in accordance with SFAS 123R, “Share-Based Payment” (“SFAS 123R”). We adopted SFAS 123R using the modified prospective transition method and consequently have not retroactively adjusted results from prior periods. Under this transition method, compensation cost associated with stock-based awards recognized for fiscal years 2006 and 2007 includes 1) amortization related to the remaining unvested portion of stock-based awards granted prior to January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123 “Accounting for Stock-Based Compensation” (“FAS 123”); and 2) amortization related to stock-based awards granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123R. In addition, we record expense over the service period in connection with shares issued under our employee stock purchase plan and stock options and restricted stock awards. The compensation expense for stock-based awards includes an estimate for forfeitures and is recognized over the service period of the award on a straight-line basis.
Prior to January 1, 2006, we accounted for stock-based awards using the intrinsic value method of accounting in accordance with APB 25, whereby the difference between the exercise price and the fair market value on the date of grant is recognized as compensation expense. Under the intrinsic value method of accounting, no compensation expense was recognized in our Statements of Income when the exercise price of our employee stock option grant equals the market price of the underlying common stock on the date of grant, and the measurement date of the option grant is certain. The measurement date is certain when the date of grant is fixed and determinable.
Advertising
Advertising costs are expensed as incurred. Advertising expense was $2,000, $26,000, and $18,000 for the years ended December 31, 2007, 2006 and 2005, respectively.
Income Taxes
We account for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes,” which requires the use of the liability method in accounting for income taxes. Under SFAS No. 109, deferred tax assets and liabilities are measured using enacted tax rates and laws that are expected to be in effect when the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the net amount expected to be realized.
Net Income Per Share
Basic net income per share is computed using the weighted-average number of common shares outstanding during the period. Diluted net income per share reflects the potential dilution of securities by adding common stock equivalents (computed using the treasury stock method) to the weighted-average number of common shares outstanding during the period, if dilutive.
Page
Notes to Financial Statements
1. Summary of Significant Accounting Policies (continued)
The following table sets forth the computation of net income per share (in thousands, except per share data):
For the years ended December 31, 2007, 2006 and 2005, respectively, 923,621, 1,393,649 and 1,058,652 options with exercise prices greater than the average market price for our common stock were excluded from the calculation of diluted net income per share because their effect is anti-dilutive.
Recent Accounting Pronouncements
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007. We do not believe that the adoption of SFAS 157 will have a material impact on our financial condition and results of operations.
In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”), including an amendment of FASB Statement No. 115, which allows an entity the irrevocable option to elect fair value for the initial and subsequent measurement for certain financial assets and liabilities on an instrument-by-instrument basis. Subsequent measurements for the financial assets and liabilities an entity elects to record at fair value will be recognized in earnings. Statement 159 also establishes additional disclosure requirements. SFAS 159 is effective for fiscal years beginning after November 15, 2007. We have not elected to adopt SFAS 159.
In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141 (revised 2007) (“SFAS 141R”), “Business Combinations” and Statement of Financial Accounting Standards No. 160 (“SFAS 160”), “Noncontrolling Interests in Consolidated Financial Statements, an amendment of Accounting Research Bulletin No. 51”. SFAS 141R will change how business acquisitions are accounted for and will impact financial statements both on the acquisition date and in subsequent periods. SFAS 160 will change the accounting and reporting for minority interests, which will be recharacterized as noncontrolling interests and classified as a component of equity. SFAS 141R and SFAS 160 are effective for us beginning in the first quarter of fiscal 2010. Early adoption is not permitted. We are currently evaluating the impact that SFAS 141R and SFAS 160 will have on our financial statements.
Page
Notes to Financial Statements
2. Stock-Based Compensation
Stock-Based Compensation Plans
On December 31, 2007, 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 6,492,666. Restricted stock units awarded under this plan generally vest over four years of continuous service in annual or semi-annual installments. 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.
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 originally authorized for issuance under the plan was 700,000. In June 2007 an additional 500,000 shares were authorized.
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 December 31, 2007, 500,533 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). Effective January 1, 2006 we began recording compensation expense associated with stock-based awards and other forms of equity compensation in accordance with SFAS 123R, “Share-Based Payment”. We adopted the modified prospective transition method provided for under SFAS 123R, and consequently have not retroactively adjusted results from prior periods.
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 the fourth quarter of 2007 we changed our estimate of the forfeiture rate from 11% to 3.5%, based on our experience of actual forfeiture rates. This resulted in incremental stock compensation expense of approximately $316,000 in the fourth quarter of fiscal 2007.
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 the first quarter of 2006.
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 year ended December 31, 2005 (in thousands, except per share data):
Page
Notes to Financial Statements
2. Stock-Based Compensation (continued)
Compensation Cost
The following table summarizes the impact of share-based compensation resulting from the application of SFAS 123R in the years ended December 31, 2007 and 2006 (in thousands, except per share amounts):
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 subjective assumptions, including expected stock price volatility, 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. Estimated volatility is based on the historical prices of our common stock over the expected life of each option. Expected life of the options is based on our history of option exercise and cancellation activity. The risk free interest rates used are based on the U.S. Treasury yield curve in effect at the time of grants for periods corresponding with the expected life of the options. We use historical data to estimate pre-vesting option forfeitures. We recognize compensation expense for the fair values of these awards, which typically have graded vesting, on a straight-line basis over the requisite service period of each of these awards.
The fair value of stock options granted was estimated using the following weighted-average assumptions:
Page
Notes to Financial Statements
2. Stock-Based Compensation (continued)
Summary of Stock Options
The following table summarizes all stock option activity under our share-based compensation plans for the year ended December 31, 2007:
The aggregate intrinsic value of options outstanding at December 31, 2007 is calculated as the difference between the exercise price of the underlying options and the market price of our common stock for the 1,940,964 shares that had exercise prices that were lower than the $5.36 market price of our common stock at December 31, 2007 (“in the money options”). The total intrinsic value of options exercised during the years ended December 31, 2007, 2006 and 2005 was $416,000, $151,000, and $192,000, respectively. The fair value of options vested during the years ended December 31, 2007, 2006 and 2005 was $1.5 million, $1.7 million, and $1.7 million, respectively. The weighted average grant date fair value of options granted during the years ended December 31, 2007, 2006 and 2005 was $2.96, $2.67, and $4.31, respectively.
The following table summarizes information concerning outstanding and exercisable stock options at December 31, 2007:
As of December 31, 2007, total unrecognized compensation cost related to stock options granted under our various plans was $1.1 million. We expect that cost to be recognized over a weighted-average period of 0.9 years.
Page
Notes to Financial Statements
2. Stock-Based Compensation (continued)
Summary of Restricted Stock Units and Restricted Stock Awards
The following table summarizes all restricted stock unit activity under our share-based compensation plans for the years ending December 31, 2007 and 2006:
Restricted stock units were granted for the first time in 2006 under our 1999 Equity Incentive Plan. 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 fiscal years 2007 and 2006 was $6.83 and $4.88, respectively, and the fair value of stock units that vested during fiscal years 2007 and 2006 was $771,000 and $289,000, respectively. As of December 31, 2007, total unrecognized compensation cost related to restricted stock units was $2.3 million. We expect that cost to be recognized over a weighted-average period of 3.0 years.
Employee Stock Purchase Plan (“ESPP”)
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:
Disclosures Pertaining to All Share-Based Compensation Plans
Cash received under all share-based payment arrangements for the years ended December 31, 2007, 2006 and 2005 was $1.2 million, $602,000, and $474,000, respectively, related to the exercise of stock options and the purchase of ESPP shares. The weighted-average grant-date fair value of options, restricted stock units and restricted stock awards granted in the years ended December 31, 2007, 2006 and 2005 was $5.32, $4.21, and $4.36 per share, respectively.
Page
Notes to Financial Statements
3. Prepaid Expenses and Other Current Assets
Prepaid expenses and other current assets consist of the following (in thousands):
4. Property and Equipment
Property and equipment consists of the following (in thousands):
Depreciation expense for the years ended December 31, 2007, 2006, and 2005 was $313,000, $350,000, and $467,000, respectively.
5. Deferred Acquisition Costs
Deferred acquisition costs consist principally of legal and accounting fees directly associated with the negotiation and execution of the Purchase Agreement for the acquisition of the Soliloquy Learning business (see Note 17). These costs will be included in the purchase price upon the closing of the transaction.
6. Other Assets
Other assets consist of the following (in thousands):
Page
Notes to Financial Statements
7. Accrued Liabilities
Accrued liabilities consist of the following (in thousands):
8. Deferred Revenue
Deferred revenue consists of the following (in thousands):
9. Bank Line of Credit
On June 5, 2007 we amended our existing revolving line of credit agreement with Comerica Bank. The maximum that can be borrowed under the agreement is $5.0 million. The line expires on December 2, 2008. Borrowing under the line of credit bears interest at a floating prime rate, or a fixed rate of LIBOR plus 2.5%. To secure the line we granted Comerica a security interest in all of our assets other than our intellectual property. We also agreed with Comerica that we will not grant a security interest in our intellectual property to any third party. Borrowings under the line are subject to various covenants. The agreement includes a letter of credit sublimit not to exceed $1.0 million. At December 31, 2007, we have an outstanding letter of credit for $206,000. There were no borrowings outstanding on the line of credit at December 31, 2007 and we were in compliance with all our covenants.
Page
Notes to Financial Statements
10. Income Taxes
All income before income taxes is derived from the United States.
The components of the provision (benefit) for income taxes are as follows (in thousands):
Differences between income taxes calculated using the federal statutory income tax rate and the provision (benefit) for income taxes were as follows (in thousands):
Deferred income taxes reflect the net tax effects of temporary differences between carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of our deferred tax assets are as follows, (in thousands):
Page
Notes to Financial Statements
10. Income Taxes (continued)
During the fourth quarter of 2007, we recorded an income tax benefit of $1.1 million. This benefit included a $1.2 million reduction in the valuation allowance related to a portion of our deferred tax assets that will more likely than not be realized. This determination was primarily based on projected taxable income. In evaluating our ability to realize our deferred tax assets we consider all available positive and negative evidence including our past operating results and our forecast of future taxable income. In determining future taxable income, we make assumptions to forecast federal and state operating income, the reversal of temporary differences, and the implementation of any feasible and prudent tax planning strategies. These assumptions require significant judgment regarding the forecasts of future taxable income, and are consistent with the forecasts used to manage our business. We intend to maintain the remaining valuation allowance until sufficient further positive evidence exists to support further reversals of the valuation allowance. Our income tax expense recorded in the future will be reduced to the extent of offsetting decreases in our valuation allowance.
As of December 31, 2007, we have U.S. federal and state net operating loss carryforwards of approximately $61.2 million and $46.5 million, respectively. The U.S. federal net operating loss carryforwards will expire at various dates beginning in 2018 through 2027 if not utilized. State net operating loss carryforwards will expire at various dates beginning in 2012 through 2017.
As of December 31, 2007, we have U.S. federal and state tax credit carryforwards of approximately $1.2 million and $0.9 million, respectively. The federal credit will expire at various dates beginning in 2011 through 2027, if not utilized. California state research and development credits can be carried forward indefinitely.
In connection with the Company’s adoption of SFAS 123R, the Company uses the “with-and-without” approach described in EITF Topic No. D-32, “Intraperiod Tax Allocation of the Tax Effect of Pretax Income from Continuing Operations” to determine the recognition and measurement of excess tax benefits. In addition, the Company has elected to account for indirect effects of stock option based awards on other tax attributes, such as research and alternative minimum tax credits, through the income statement. Accordingly, the Company has elected to recognize excess tax benefits from stock option exercises in additional paid in capital only if an incremental income tax benefit would be realized after considering all other tax attributes presently available to the Company.
Therefore, included in the net operating loss carryforwards are losses created by the exercise of stock options. Although these net operating loss carryforwards are reflected in total U.S. net operating tax loss carryforwards, pursuant to SFAS 123(R), deferred tax assets associated with these deductions are only recognized to the extent that they reduce taxes payable. Further, these recognized deductions are treated as direct increases to stockholders’ equity and as a result do not impact the Statement of Operations. To the extent stock-option related deductions are not recognized pursuant to SFAS123(R), the unrecognized benefit is not reflected on the Consolidated Balance Sheet. Accordingly, the Company has reduced deferred tax assets by approximately $1.2 million which represents the unrecognized benefit from stock-option related net operating loss carryforwards as of December 31, 2007, that is potentially available for utilization in future years.
Net operating loss carryforwards and credit carryforwards reflected above are limited due to ownership changes as provided in the Internal Revenue Code and similar state provisions.
Accounting for Uncertainty in Income Taxes
Effective January 1, 2007, we adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of SFAS No. 109” (“FIN 48”). FIN 48 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. There was not a material impact on our financial position and results of operations as a result of the adoption of the provisions of FIN 48. At December 31, 2007, we had a liability for unrecognized tax benefits of $1,876,000 (of which $25,000, if recognized, would favorably affect the company’s effective tax rate). We do not believe there will be any material changes in our unrecognized tax positions over the next twelve months.
Page
Notes to Financial Statements
10. Income Taxes (continued)
Interest and penalty costs related to unrecognized tax benefits are classified as a component of “Income Tax Expense” in the accompanying statement of operations and the corresponding liability in “Income Taxes Payable” or “Prepaid Income Taxes” in the accompanying balance sheet. We recognized $5,000 of interest expense related to unrecognized tax benefits for the year ended December 31, 2007.
We file income tax returns in the U.S. federal jurisdiction and various state jurisdictions. We are subject to U.S. federal income tax examination for calendar tax years ending 2005 through 2007. We recently completed an audit from the I.R.S for our 2004 and earlier tax years. Additionally, we are subject to various state income tax examinations for the 1997 through 2007 calendar tax years.
A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows: (in thousands):
The Company accounts for any applicable interest and penalties on uncertain tax positions as a component of income tax expense. The liability for uncertain income taxes as of the date of adoption (January 1, 2007) and December 31, 2007 includes interest and penalties of zero and $ 25,000, respectively.
11. Stockholders’ Equity (Deficit)
Common Stock
At December 31, 2007, we had reserved shares of common stock for future issuance as follows:
Common Stock Warrants
In 2001, we issued a fully vested non-forfeitable warrant to purchase 1,375,000 shares of our common stock at an exercise price of $8.00 per share. The warrant was issued to WPV, Inc., an affiliate of a significant former stockholder of ours, in connection with the guarantee of a line of credit to us. The warrant is outstanding and will expire if unexercised by March 9, 2008.
Page
12. Commitments and Contingencies
Leases
We lease our Oakland, California corporate office facility and our Tucson, Arizona office under non-cancelable operating leases with terms expiring in 2013 and 2009, respectively. In early 2008, we entered into a new lease for our Reading Assistant operations in Waltham, Massachusetts for approximately 6,000 square feet that expires in September 2011. This lease, as well as the existing Waltham lease that expires on March 31,2008, is included in the table.
Future minimum payments under these leases as of December 31, 2007 are as follows (in thousands):
Rent expense under all operating leases was $1.0 million for each of the years ended December 31, 2007, 2006 and 2005.
License Agreement
In September 1996, we entered into a license agreement with a university for the use of the intellectual property underlying its most significant current products. In exchange for the license, which expires in 2014, we issued stock and paid a license-issue fee. The agreement also provided for milestone payments, all of which have been made, and for royalties based on booked sales of products using the licensed technology. Royalty expenses were $1,028,000, $868,000, and $1,048,000 for the years ended December 31, 2007, 2006 and 2005, respectively, and are included in cost of product revenues. Annual minimum guaranteed royalty payments are $150,000.
If we lose or are unable to maintain the license agreement during the term of the underlying patents, it would adversely affect our business. The university may terminate the license agreement if we fail to perform or violate its terms without curing the violation within 60 days of receiving written notice of the violation.
Litigation
Litigation with Former Sales Representative
On January 23, 2008, Robert G. (Jerry) Smith, a former account manager in Florida, filed a complaint against us in US District Court for the Middle District of Florida. The lawsuit claims breach of contract for unpaid wages of approximately $423,000. Smith alleges that he is owed additional commission relating to large sale transaction in the second quarter of 2007. We are in the early stages of this proceeding, discovery has not yet started.
Litigation with School District Customer
On October 22, 2007, we were sued by the Christina School District (the “District”) in the US District Court for the District of Delaware. The District had previously been sued by investors who are the assignees of the lessor under a Master Lease Purchase Agreement (the “Lease Agreement”) entered into by the District in 2003. The District ceased making payments under the Lease Agreement and the investors have claimed that the District breached the Lease Agreement. The District filed a third party complaint against us, claiming that we must refund amounts paid to us by the District for training and consulting under our contracts with the District. Because the District decided not to use our products, it did not therefore use all of the services specified in the contract. The third party complaint alleges unjust enrichment against us. The District states that the amount it is seeking is approximately $220,000. We have filed a motion to dismiss the complaint, which has not yet been decided.
Page
Notes to Financial Statements
12. Commitments and Contingencies (continued)
We believe that these claims are not meritorious and that we do not have any significant liability to these claimants. We therefore do not believe that the resolution of these matters will have a material adverse effect on our financial position or results of operations.
13. 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 December 31, 2007.
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 lessors 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 our behalf. 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 December 31, 2007 or 2006.
14. Employee Retirement and Benefit Plan
We have a defined contribution retirement plan under Section 401(k) of the Internal Revenue Code, which covers substantially all employees. Eligible employees may contribute amounts to the plan, via payroll withholding, subject to certain limitations. In 2007 we started to match contributions by plan participants at a rate of 3% of salary, with an annual maximum of $2,000 per participant. For the year ended December 31, 2007 our matching contributions were $280,000.
15. Related Party Transactions
On September 30, 2003, we entered into an agreement with Posit Science Corporation (“Posit Science”), formerly Neuroscience Solutions Corporation, to provide Posit Science with exclusive rights in the healthcare field to certain intellectual property, patents and software we own or license, 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 Posit Science.
The rights were acquired by Posit Science for a combination of cash, stock and future royalties. Posit Science paid $500,000 cash, of which $448,000 was recognized as other income during the year ended December 31, 2003. The balance was recognized over the next nine months as services were provided to Posit Science. Amounts received to date and any future receipts are being reported as other income as we do not consider the sale of these rights to be part of our recurring operations. Under the agreement, we will receive net royalties between 2% to 4% on products sold by Posit Science that use our patents or software.
We have a 3.5% equity interest in Posit Science. We recorded royalty income from Posit Science of $246,000, $150,000, and $50,000 in fiscal years 2007, 2006 and 2005, respectively. There is an amount of $158,000 due from Posit Science at December 31, 2007.
In July 2007 Michael A. Moses joined our Board of Directors as Vice Chair and also entered into a consulting agreement with us. The consulting agreement provides for a consulting fee of $40,000 per year and two stock options, both with a five year term and at a per share exercise price of $7.15, the closing price of the Company’s Common Stock on July 25, 2007. The first option grant for 80,000 shares vests over four years, with a one year cliff with ratable monthly vesting thereafter. The second option for 100,000 shares vests only in the event the per share price of the Company’s common stock reaches and maintains for 20 consecutive business days a specified target closing price as follows: 25,000 shares vesting at each target stock price of $15, $20, $25, and $30.
Page
Notes to Financial Statements
15. Related Party Transactions (continued)
We also have in place consulting agreements with two of our founders, who are also members of our Board of Directors. Dr. Tallal provides ongoing consulting in the areas of customer relationships and research planning and in 2007, received a retainer of approximately $83,000 for those services. Dr. Merzenich provides consulting services including public speaking, meetings with third parties and other projects as agreed from time to time. Dr. Merzenich is paid a consulting fee of $2,000 per day.
16. Interim Financial Information (unaudited)
Quarterly financial data (in thousands, except per share amounts):
Page
Notes to Financial Statements
17. Subsequent Event: Acquisition
On January 7, 2008 we entered into an Asset Purchase Agreement (the “Purchase Agreement”) with JTT Holdings Inc. dba Soliloquy Learning, (“JTT”), pursuant to which we agreed to acquire from JTT the Soliloquy Reading Assistant™ product line and substantially all of the other assets of the Soliloquy Learning business, based in Waltham, Massachusetts, for cash consideration.
Under the terms of the Purchase Agreement, we paid at closing $9.7 million and retained $1.0 million in satisfaction of outstanding indebtedness owed to us by JTT. Of the aggregate cash amount, $1,070,000 was withheld at the closing and placed into a third party escrow to secure JTT’s indemnification obligations to us under the Purchase Agreement. We assumed certain specified liabilities associated with the Soliloquy business pursuant to the Purchase Agreement.
At December 3, 2007, we had incurred $319,000 in costs related to this acquisition. These costs are classified as deferred acquisition costs on our balance sheet, and will be included as part of the purchase price allocation.
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, such as this Annual Report on Form 10-K, 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 Annual Report on Form 10-K, and concluded that our disclosure controls and procedures were effective as of December 31, 2007.
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 that occurred during the year ended December 31, 2007 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Management’s Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act. Our internal control system was designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes, in accordance with generally accepted accounting principles. Because of inherent limitations, a system of internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate due to change in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Page
Our management, including our Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of our internal control over financial reporting using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on its evaluation, our management concluded that our internal control over financial reporting was effective as of the end of the period covered by this report.
This annual report does not include an audit report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to audit by the Company’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report.
ITEM 9B.
ITEM 9B.
OTHER INFORMATION
None.
Page
PART III
ITEM 10.
ITEM 10.
DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item with respect to our executive officers is contained in Part I “Executive Officers” and such information is also incorporated by reference in this section.
Information required by this item respecting our directors, audit committee and code of ethics is set forth under the caption “Proposal 1: Election of Directors” in our Proxy Statement relating to our 2008 Annual Meeting of Stockholders (the “Proxy Statement”) and is incorporated by reference into this Form 10-K Report. The Proxy Statement will be filed with the Securities and Exchange Commission in accordance with Rule 14a-6(c) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). With the exception of the foregoing information and other information specifically incorporated by reference into this Form 10-K Report, the Proxy Statement is not being filed as a part hereof.
Information with respect to compliance with Section 16(a) of the Exchange Act is set forth under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” in the Proxy Statement and is incorporated by reference into this Form 10-K Report.
ITEM 11.
ITEM 11.
EXECUTIVE COMPENSATION
Information required by this item concerning compensation of executive officers and directors is set forth under the caption “Executive Compensation” in the Proxy Statement and is incorporated by reference into this Form 10-K Report.
Information required by this item concerning security ownership of certain beneficial owners and management is set forth under the caption “Security Ownership of Certain Beneficial Owners and Management” in the Proxy Statement and is incorporated by reference into this Form 10-K Report.
Information required by this item concerning shares authorized for issuance under equity compensation plans approved by stockholders and not approved by stockholders is set forth under the caption “Equity Compensation Plan Information” in the Proxy Statement and is incorporated by reference into this Form 10-K Report.
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information required by this item concerning certain relationships and related transactions is set forth under the captions “Employment Agreement” and “Certain Transactions” in the Proxy Statement and is incorporated by reference into this Form 10-K Report.
ITEM 14.
ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES
Information required by this item concerning the independent auditor’s fees and services is set forth under the caption “Ratification of Selection of Independent Registered Public Accounting Firm” in the Proxy Statement and is incorporated by reference into this Form 10-K Report.
Page
PART IV
ITEM 15.
ITEM 15.
EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a) Documents filed as part of this report:
(1) Financial Statements
Report of Ernst & Young LLP, Independent Registered Public Accounting Firm
Balance Sheet - December 31, 2007 and 2006
Statements of Income - Years Ended December 31, 2007, 2006 and 2005
Statements of Stockholders’ Equity (Deficit) - Years Ended December 31, 2007, 2006 and 2005
Statements of Cash Flows - Years Ended December 31, 2007, 2006 and 2005
Notes to Financial Statements
(2) Financial Statement Schedules
As required under Item 8, Financial Statements and Supplementary Data, the financial statement schedule of the Company is provided in this separate section. The financial statement schedule included in this section is as follows:
Schedule II - Valuation and Qualifying Accounts (in thousands):
(b) Exhibits
A list of exhibits filed herewith is contained in the exhibit index that immediately precedes such exhibits and is incorporated herein by reference.
Page
EXHIBITS
Page
Page
23)
Incorporated by reference to exhibits previously filed with the Registrant’s Form 8-K filed on July 26, 2007 (File No. 000-24547).
24)
Incorporated by reference to exhibits previously filed with the Registrant’s Form 8-K filed on December 21, 2007 (File No. 000-24547).
†
Certain portions of this exhibit have been omitted based upon confidential treatment granted by the Securities and Exchange Commission for portions of the referenced exhibit.
*
Management contract or compensatory plan or arrangement.
Page
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
SCIENTIFIC LEARNING CORPORATION
By /s/ Robert C. Bowen
March 7, 2008
Robert C. Bowen
Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
SIGNATURES
TITLE
DATE
/s/ Robert C. Bowen
Robert C. Bowen
Chairman, Chief Executive Officer and Director (Principal Executive Officer)
March 7, 2008
/s/ Jane A. Freeman
Jane A. Freeman
Executive Vice President, Chief Financial Officer, and Treasurer (Principal Financial and Accounting Officer)
March 7, 2008
/s/ Dr. Michael M. Merzenich
Dr. Michael M. Merzenich
Director
March 7, 2008
/s/ Dr. Paula A. Tallal
Dr. Paula A. Tallal
Director
March 7, 2008
/s/ Carleton A. Holstrom
Carleton A. Holstrom
Director
March 7, 2008
/s/ Rodman W. Moorhead, III
Rodman W. Moorhead, III
Director
March 7, 2008
/s/ Ajit M. Dalvi
Ajit Dalvi
Director
March 7, 2008
/s/ Dr. Joseph B. Martin
Dr. Joseph Martin
Director
March 7, 2008
/s/ Edward Vermont Blanchard, Jr.
Edward Vermont Blanchard, Jr.
Director
March 7, 2008
/s/ David W. Smith
David W. Smith
Director
March 7, 2008
/s/ Michael A. Moses
Michael Moses
Director
March 7, 2008
/s/ Lance R. Odden
Lance Odden
Director
March 7, 2008