** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 
|                                                  |   | **(Mark One)**                                                                                 |
|-------------------------------------------------------|--------|------------------------------------------------------------------------------------------------|
|                                                  |   |                                                                                           |
| ý                                                |   | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**  |
|                                                  |   |                                                                                           |
| **For the quarterly period ended June 30, 2003** |
|                                                  |   |                                                                                           |
| **Or**                                                |
|                                                  |
| o                                                     |   | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934** |
|                                                  |   |                                                                                           |
| **Commission File Number 000-24289**                  |

 

**CLICK2LEARN, INC.**

(Exact name of registrant as specified in itscharter)

 
| **Delaware**                                                    |   | **91-1276003**                       |
|-----------------------------------------------------------------|--------|--------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |   | (I.R.S. Employer Identification No.) |
|                                                            |   |                                 |
| **110-110th Avenue NE, Bellevue, Washington**                   |   | **98004**                            |
| (Address of principal executive offices)                        |   | (Zip Code)                           |
|                                                            |   |                                 |
| **(425) 462-0501**                                              |
| (Registrant’s telephone number, including  area code)      |

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.  Yes  ý    No  o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act).  Yes  o    No  ý

 

The number of shares outstanding of the issuer’s Common Stock, parvalue $0.01, as of July 15, 2003 was 32,397,808 shares.

 

 

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**CLICK2LEARN,INC.**

 

**FORM10 -Q**

 

**Forthe Quarter Ended June 30, 2003**

 

**TABLEOF CONTENTS**

 
| **PART I – FINANCIAL INFORMATION** |
|-----------------------------------------|
|                                    |   |
| Item 1.                                 | Financial  Statements |
|                                    |   |
|                                    | Unaudited Condensed Consolidated Balance  Sheets as of June 30, 2003 and December 31, 2002 |
|                                    |   |
|                                    | Unaudited Condensed Consolidated Statements  of Operations for the three months ended June 30, 2003 and 2002 |
|                                    |   |
|                                    | Unaudited  Condensed Consolidated Statements of Cash Flows for the three months ended  June 30, 2003 and 2002 |
|                                    |   |
|                                    | Notes to Unaudited Condensed Consolidated  Financial Statements |
|                                    |   |
| Item 2.                                 | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |
|                                    |   |
| Item 3.                                 | Quantitative  and Qualitative Disclosures About Market Risk |
|                                    |   |
| Item 4.                                 | Controls  and Procedures |
|                                    |   |
| **PART II – OTHER INFORMATION**    |
|                                    |   |
| Item 1.                                 | Legal Proceedings |
|                                    |   |
| Item 2.                                 | Change in Securities and Use of Proceeds |
|                                    |   |
| Item  3.                                | Defaults  upon Senior Securities |
|                                    |   |
| Item 4.                                 | Submission of Matters to a Vote of  Securities Holders |
|                                    |   |
| Item 5.                                 | Other Information |
|                                    |   |
| Item 6.                                 | Exhibits and Reports on Form 8-K |
|                                    |   |
| **SIGNATURES**                          |

 

2

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**PARTI****– FINANCIALINFORMATION**

 

**Item 1****.  FinancialStatements**

 

**CLICK2LEARN, INC. AND SUBSIDIARIESUNAUDITED CONDENSED CONSOLIDATEDBALANCE SHEETS(In thousands except share data)**

 
|                                                                                                                                           |   | **June 30,  2003** |   | **December 31,  2002** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|--------|-----------------------------|--------|
| **Assets**                                                                                                                                     |   |                    |   |                        |   |
|                                                                                                                                           |   |                    |   |                        |   |
| Current assets:                                                                                                                                |   |                    |   |                        |   |
| Cash and cash equivalents                                                                                                                      |   | $                       | 15,750 |                        | $      | 3,586 |   |
| Accounts receivable, net of allowance for  returns and doubtful accounts of $861 in 2003 and $927 in 2002                                      |   | 9,458                   |   | 10,785                      |   |
| Prepaid royalties and licenses                                                                                                                 |   | 76                      |   | 157                         |   |
| Other                                                                                                                                          |   | 1,352                   |   | 1,619                       |   |
| Total current assets                                                                                                                           |   | 26,636                  |   | 16,147                      |   |
| Property and equipment, net                                                                                                                    |   | 1,015                   |   | 1,214                       |   |
| Goodwill                                                                                                                                       |   | 2,877                   |   | 2,877                       |   |
| Intangible assets, net                                                                                                                         |   | 4,109                   |   | 4,636                       |   |
| Other                                                                                                                                          |   | 589                     |   | 599                         |   |
| Total assets                                                                                                                                   |   | $                       | 35,226 |                        | $      | 25,473 |   |
|                                                                                                                                           |   |                    |   |                        |   |
| **Liabilities and Stockholders’ Equity**                                                                                                  |   |                    |   |                        |   |
|                                                                                                                                           |   |                    |   |                        |   |
| Current liabilities:                                                                                                                           |   |                    |   |                        |   |
| Accounts payable                                                                                                                               |   | $                       | 1,426  |                        | $      | 2,934 |   |
| Accrued compensation and benefits                                                                                                              |   | 2,254                   |   | 2,294                       |   |
| Deferred revenue                                                                                                                               |   | 4,377                   |   | 4,435                       |   |
| Short term debt                                                                                                                                |   | 3,213                   |   | 2,400                       |   |
| Other                                                                                                                                          |   | 935                     |   | 1,184                       |   |
| Total current liabilities                                                                                                                      |   | 12,205                  |   | 13,247                      |   |
| Other noncurrent liabilities                                                                                                                   |   | 222                     |   | —                      |   |
| Total liabilities                                                                                                                              |   | 12,427                  |   | 13,247                      |   |
|                                                                                                                                           |   |                    |   |                        |   |
| Stockholders’ equity:                                                                                                                     |   |                    |   |                        |   |
| Preferred stock, $0.01 par value;  authorized 5,000,000 shares; issued and outstanding no shares in 2003 and  2002                             |   | —                  |   | —                      |   |
| Common stock, $0.01 par value; authorized  100,000,000 shares, issued and outstanding 32,397,808 shares in 2003 and  24,600,114 shares in 2002 |   | 325                     |   | 246                         |   |
| Additional paid-in capital                                                                                                                     |   | 254,619                 |   | 242,570                     |   |
| Accumulated deficit                                                                                                                            |   | (231,689                | )      | (230,008                    | )      |
| Accumulated other comprehensive loss                                                                                                           |   | (456                    | )      | (582                        | )      |
| Total stockholders’ equity                                                                                                                |   | 22,799                  |   | 12,226                      |   |
| Total liabilities and stockholders’ equity                                                                                                |   | $                       | 35,226 |                        | $      | 25,473 |   |

 

See accompanyingnotes to unaudited condensed Consolidated Financial Statements

 

3

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**CLICK2LEARN, INC. AND SUBSIDIARIESUNAUDITED CONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS(In thousands, except per share data)**

 
|                                                           |   | **Three Months Ended June 30,** |   | **Six Months Ended June 30,** |   |
|----------------------------------------------------------------|--------|--------------------------------------|--------|------------------------------------|--------|
|                                                           |   | **2003**                             |   | **2002**                           |   | **2003** |   | **2002** |   |
|                                                           |   |                                 |   |                               |   |   |   |   |   |
| Revenue:                                                       |   |                                 |   |                               |   |   |   |   |   |
| Platforms                                                      |   | $                                    | 6,871  |                               | $      | 5,518 |   | $ | 13,423 |   | $ | 10,936 |   |
| Tools                                                          |   | 784                                  |   | 1,236                              |   | 1,558 |   | 2,495 |   |
| Content services                                               |   | 474                                  |   | 848                                |   | 1,148 |   | 1,481 |   |
| Total revenue                                                  |   | 8,129                                |   | 7,602                              |   | 16,129 |   | 14,912 |   |
|                                                           |   |                                 |   |                               |   |   |   |   |   |
| Cost of revenue:                                               |   |                                 |   |                               |   |   |   |   |   |
| Platforms                                                      |   | 1,476                                |   | 1,480                              |   | 3,050 |   | 3,054 |   |
| Tools                                                          |   | 133                                  |   | 287                                |   | 258 |   | 682 |   |
| Content services                                               |   | 445                                  |   | 652                                |   | 1,017 |   | 1,307 |   |
| Total cost of revenue                                          |   | 2,054                                |   | 2,419                              |   | 4,325 |   | 5,043 |   |
| Gross margin                                                   |   | 6,075                                |   | 5,183                              |   | 11,804 |   | 9,869 |   |
|                                                           |   |                                 |   |                               |   |   |   |   |   |
| Operating expenses:                                            |   |                                 |   |                               |   |   |   |   |   |
| Research and development                                       |   | 1,913                                |   | 2,404                              |   | 3,397 |   | 4,685 |   |
| Sales and marketing                                            |   | 3,499                                |   | 4,831                              |   | 7,177 |   | 9,263 |   |
| General and administrative                                     |   | 1,411                                |   | 1,435                              |   | 2,751 |   | 3,038 |   |
| Total operating expenses                                       |   | 6,823                                |   | 8,670                              |   | 13,325 |   | 16,986 |   |
| Operating loss from continuing operations                      |   | (748                                 | )      | (3,487                             | )      | (1,521 | ) | (7,117 | ) |
|                                                           |   |                                 |   |                               |   |   |   |   |   |
| Other income (expense)                                         |   | (46                                  | )      | (3                                 | )      | (93 | ) | 13 |   |
| Equity in losses of affiliate                                  |   | (25                                  | )      | (75                                | )      | (50 | ) | (150 | ) |
| Loss from continuing operations before  income taxes           |   | (819                                 | )      | (3,565                             | )      | (1,664 | ) | (7,254 | ) |
|                                                           |   |                                 |   |                               |   |   |   |   |   |
| Income tax                                                     |   | (7                                   | )      | —                             |   | (17 | ) | — |   |
| Loss from continuing operations                                |   | (826                                 | )      | (3,565                             | )      | (1,681 | ) | (7,254 | ) |
|                                                           |   |                                 |   |                               |   |   |   |   |   |
| Loss from discontinued operations                              |   | —                               |   | (656                               | )      | — |   | (2,651 | ) |
| Net loss                                                       |   | $                                    | (826   | )                                  | $      | (4,221 | ) | $ | (1,681 | ) | $ | (9,905 | ) |
|                                                           |   |                                 |   |                               |   |   |   |   |   |
| Amounts per share, basic and diluted:                          |   |                                 |   |                               |   |   |   |   |   |
| Loss from continuing operations                                |   | $                                    | (0.03  | )                                  | $      | (0.14 | ) | $ | (0.07 | ) | $ | (0.29 | ) |
| Loss from discontinued operations                              |   | —                               |   | (0.03                              | )      | — |   | (0.11 | ) |
| Net loss                                                       |   | $                                    | (0.03  | )                                  | $      | (0.17 | ) | $ | (0.07 | ) | $ | (0.40 | ) |
|                                                           |   |                                 |   |                               |   |   |   |   |   |
| Weighted average common shares outstanding,  basic and diluted |   | 25,757                               |   | 24,271                             |   | 25,288 |   | 24,235 |   |

 

Seeaccompanying notes to unaudited condensed Consolidated Financial Statements

 

4

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**CLICK2LEARN, INC. AND SUBSIDIARIESUNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands)**

 
|                                                                                        |   | **Six Months  Ended June 30,** |   |
|---------------------------------------------------------------------------------------------|--------|-------------------------------------|--------|
|                                                                                        |   | **2003**                            |   | **2002** |   |
| Cash flows from operating activities:                                                       |   |                                |   |   |   |
| Continuing operations:                                                                      |   |                                |   |   |   |
| Net loss                                                                                    |   | $                                   | (1,681 | ) | $ | (7,254 | ) |
| Adjustments to reconcile net loss to net  cash provided by continuing operating activities: |   |                                |   |   |   |
| Depreciation and amortization                                                               |   | 1,168                               |   | 1,196 |   |
|                                                                                        |   |                                |   |   |   |
| Write-off property and equipment                                                            |   | —                              |   | 270 |   |
| Provision for returns and doubtful accounts                                                 |   | 317                                 |   | 833 |   |
| Amortization of discount on debt                                                            |   | 44                                  |   | — |   |
| Stock compensation expense                                                                  |   | —                              |   | 5 |   |
| Equity losses of affiliate                                                                  |   | 50                                  |   | 150 |   |
| Net change in certain operating assets and  liabilities                                     |   | 236                                 |   | 5,100 |   |
| Net cash provided by continuing operating  activities                                       |   | 134                                 |   | 300 |   |
| Discontinued operations:                                                                    |   |                                |   |   |   |
| Loss from discontinued operations                                                           |   | —                              |   | (2,651 | ) |
| Gain on sale of assets                                                                      |   | —                              |   | (927 | ) |
| Net cash used in discontinued operating  activities                                         |   | —                              |   | (3,578 | ) |
| Net cash provided by (used in) operating  activities                                        |   | 134                                 |   | (3,278 | ) |
| Cash flows from investing activities:                                                       |   |                                |   |   |   |
| Continuing operations:                                                                      |   |                                |   |   |   |
| Purchase of property and equipment                                                          |   | (442                                | )      | (2,880 | ) |
| Other                                                                                       |   | (40                                 | )      | 16 |   |
| Net cash used in continuing investing  activities                                           |   | (482                                | )      | (2,864 | ) |
| Discontinued operations:                                                                    |   |                                |   |   |   |
| Proceeds from sale of assets                                                                |   | —                              |   | 1,000 |   |
| Net cash provided by discontinued  activities                                               |   | —                              |   | 1,000 |   |
| Net cash used in investing activities                                                       |   | (482                                | )      | (1,864 | ) |
| Cash flows from financing activities:                                                       |   |                                |   |   |   |
| Repayments on debt                                                                          |   | (13,318                             | )      | (263 | ) |
| Proceeds from borrowings                                                                    |   | 13,576                              |   | 400 |   |
| Proceeds from exercise of stock options                                                     |   | —                              |   | 95 |   |
| Net proceeds from sale of common stock                                                      |   | 12,128                              |   | 335 |   |
| Net cash provided by financing activities                                                   |   | 12,386                              |   | 567 |   |
| Effect of foreign exchange rate changes on  cash                                            |   | 126                                 |   | 1 |   |
| Net increase (decrease) in cash and cash  equivalents                                       |   | 12,164                              |   | (4,574 | ) |
| Cash and cash equivalents at beginning of  period                                           |   | 3,586                               |   | 9,553 |   |
| Cash and cash equivalents at end of period                                                  |   | $                                   | 15,750 |   | $ | 4,979 |   |

 

See accompanyingnotes to unaudited condensed Consolidated Financial Statements

 

5

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CLICK2LEARN, INC.

NOTES TO UNAUDITEDCONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

**NOTE1:  SUMMARY OF SIGNIFICANT ACCOUNTINGPOLICIES**

 

(a) Description of Business

 

Click2learn, Inc.(“Click2learn”) develops, markets, distributes, and supports an integratedsuite of enterprise learning software products.  Click2learn’s markets are worldwide and include a broad range ofindustries.

 

(b) Basis of Presentation

 

The accompanying unaudited condensedconsolidated financial statements of Click2learn, Inc., (“Click2learn”) includethe accounts of Click2learn and its wholly-owned subsidiaries.  All significant intercompany transactionshave been eliminated in consolidation.

 

These statements reflect all normal recurring adjustmentswhich, in theopinion of management, are necessary for a fair presentation of the financialposition and results of operations for the periods presented.  Interim results of operations for the threeand six months ended June 30, 2003 are not necessarily indicative of theoperating results for the full fiscal year. Factors that may affect such operating results, include, but are notlimited to, those discussed in **“Factors That May Affect Future Results ofOperations.”**  Certaininformation and footnote disclosures normally included in financial statementsprepared in conformity with accounting principles generally accepted in theUnited States of America have been condensed or omitted pursuant to the rulesand regulations of the Securities and Exchange Commission.

 

These condensed consolidated financialstatements should be read in conjunction with the consolidated financialstatements and related notes included in Click2learn’s Annual Report on Form10-K for the year ended December 31, 2002.

 

(c) Other Current Assets

 

The following table sets forth the componentsof other current assets (in thousands):

 
|                       |   | **June 30,  2003** |   | **December 31,  2002** |   |
|----------------------------|--------|-------------------------|--------|-----------------------------|--------|
| Prepaid expense            |   | $                       | 514    |                        | $      | 430 |   |
| Prepaid insurance          |   | 497                     |   | 618                         |   |
| Other                      |   | 341                     |   | 571                         |   |
| Total other current assets |   | $                       | 1,352  |                        | $      | 1,619 |   |

 

(d) Revenue Recognition

 

Click2learn recognizes revenue pursuant tothe requirements of Statement of Position No. 97-2, *Software Revenue Recognition* (“SOP 97-2”), as amended byStatement of Position No. 98-9, *SoftwareRevenue Recognition with Respect to Certain Arrangements.* Under SOP97-2, revenue attributable to an element in a customer arrangement isrecognized when persuasive evidence of an arrangement exists and delivery hasoccurred, provided the fee is fixed or determinable, collectibility is probableand the arrangement does not require significant customization of the software.

 

For all sales, Click2learn uses either abinding purchase order or signed agreement, depending on the nature of thetransaction, as evidence of an arrangement. Sales through its significantresellers are evidenced by a master agreement governing the relationship.

 

6

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For software license fees in single elementarrangements and multiple element arrangementsthat do not include customizationor consulting services, delivery typically is deemed to occur when the productis shipped to customers.

 

At the time of each transaction, Click2learnassesses whether the fee associated with its revenue is fixed and determinableand whether or not collection is probable. Click2learn assesses whether the feeis fixed and determinable based on the payment terms associated with thetransaction. If a significant portion of a fee is due after Click2learn’snormal payment terms, based upon a variable matrix such as a minimum level ofdistribution or subject to refund (other than refunds for warranty claims orits uncured defaults), Click2learn accounts for the fee as not being fixed anddeterminable. In these cases, Click2learn defers revenue and recognizes it whenit becomes due and payable.

 

Click2learn assesses the probability ofcollection based on a number of factors, including past transaction historywith the customer and the current financial condition of the customer.Click2learn does not request collateral from its customers. If Click2learndetermines at the time of the transaction that collection of a fee is notprobable, it defers revenue until payment is received.

 

For multiple element arrangements, whencompany-specific objective evidence of fair value exists for all of theundelivered elements of the arrangement, but does not exist for one or more ofthe delivered elements in the arrangement, Click2learn recognizes revenue underthe residual method. Under the residual method, at the outset of the arrangementwith a customer, Click2learn defers revenue for the fair value of itsundelivered elements such as consulting services and product support andupgrades, and recognizes the revenue for the remainder of the arrangement feeattributable to the elements initially delivered, such as software licenses,when the criteria in SOP 97-2 have been met. Company-specific objectiveevidence is established for support and upgrades of standard products for whichno installation or customization is required based upon the amounts Click2learncharges when support and upgrades are sold separately. For multiple elementarrangements involving installation or customization, company-specificobjective evidence is established for support and maintenance arrangements ifits customers have an optional annual renewal rate specified in the arrangementand the rate is substantive. Company-specific objective evidence is establishedfor consulting and installation services based on the hourly rates Click2learncharges for its employees when they are performing these services providedClick2learn has the ability to accurately estimate the hours required tocomplete a project based upon its experience with similar projects.

 

Professional services revenue is recognizedfrom fixed price contracts as services are provided or by using thepercentage-of-completion method of accounting, based on the ratio of laborcosts incurred to the total estimated project cost, for individual fixed-pricecontracts. Provisions for any estimated losses on uncompleted contracts aremade in the period in which such losses become evident. Professional servicesrevenue from time and materials contracts and training services is recognizedas revenue as services are performed.

 

Click2learn recognizes revenue from non-refundableminimum royalty agreements from distributors or resellers upon delivery ofproduct to the distributor or reseller, provided no significant obligationsremain outstanding and the conditions of SOP 97-2 have been met.  If minimum royalties are exceeded, theadditional royalties are recognized as revenue when earned, based on thecontractual reporting obligations.

 

Revenue from subscriptionlicenses, hosting agreements and support agreements is recognized on astraight-line basis over the life of the contract.

 

(e) Net Loss Per Share

 

Basic net lossper share is computed by dividing the net loss by the weighted average numberof common shares outstanding during the period.  Diluted per share amounts reflect the weighted average

 

7

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number of common and dilutiveshares outstanding during the period. As Click2learn had a net loss in each ofthe periods presented, basic and diluted net loss per share are the same.

 

Excluded from the computation of diluted loss per share for the threeand six months ended June 30, 2003 are options to acquireapproximately  6,115,810 shares ofcommon stock with a weighted average exercise price of $3.81 and warrants topurchase 6,937,055 shares of common stock with a weighted average exerciseprice of $3.34 because their effects would be anti-dilutive. Options to acquireapproximately 5,396,505 shares of common stock with a weighted average exerciseprice of $6.02 and warrants to purchase 3,633,686 shares of common stock with aweighted exercise share price of $5.75 have been excluded from the computationof diluted earnings per share for the three and six months ended June 30,2002 because their effects would be anti-dilutive.

 

The change in common stock and additional paid-in capital reflects theprivate placement to accredited investors of 7,460,000 shares of our commonstock and warrants to purchase an additional 2,611,225 shares of our commonstock on June 20, 2003 and stock purchase for the Employee Stock PurchasePlan on January 31, 2003.

 

**(f)Derivative Financial Instruments**

** **

Click2learn had no derivative financial instruments outstanding atJune 30, 2003 or December 31, 2002.

 

(g) Comprehensive Loss and Accumulated OtherComprehensive Loss

** **

The following table sets forth the components ofcomprehensive loss for the periods presented below (in thousands):

 
|                                    |   | **Three  Months Ended  June 30,** |       | **Six Months  Ended  June 30,** |       |
|-----------------------------------------|--------|----------------------------------------|------------|--------------------------------------|------------|
|                                    |   | **2003**                               |       | **2002**                             |       | **2003** |   | **2002** |   |
|                                    |   |                                   | ** ** |                                 | ** ** |   | ** ** |   | ** ** |
| Net loss                                |   | $                                      | (826       | )                                    | $          | (4,221 | ) | $ | (1,681 | ) | $ | (9,905 | ) |
| Foreign currency translation adjustment |   | 66                                     |       | 83                                   |       | 126 |   | 1 |   |
| Total comprehensive loss                |   | $                                      | (760       | )                                    | $          | (4,138 | ) | $ | (1,555 | ) | $ | (9,904 | ) |

** **

**Accumulated other comprehensive loss atJune 30, 2003 and 2002 consists of foreign currency translationadjustments.**

** **

(h)Stock-Based Compensation

 

Click2learn applies theintrinsic-value-based method of accounting prescribed by Accounting PrinciplesBoard Opinion No. 25 (“APB 25”), *Accountingfor Stock Issued to Employees,*and related interpretations includingFinancial Accounting Standards Board Interpretation No. 44 (“FIN 44”),*Accounting for Certain Transactions Involving StockCompensation, an interpretation of APB 25*, to account for itsfixed-plan stock options.  Under thismethod, compensation expense is recorded only if the current market price ofthe underlying stock exceeded the exercise price on the date of the grant.  Statement of Financial Accounting StandardsNo. 123 (“SFAS 123”), *Accounting forStock-Based Compensation*, established accounting and disclosurerequirements using a fair-value-based method of accounting for stock-basedemployee compensation plans.  As allowedby SFAS 123, Click2learn has elected to continue to apply theintrinsic-value-based method of accounting described above, and has adoptedonly the disclosure requirements of SFAS 123. The following table illustrates the effect on net loss if thefair-value-based method had been applied to all outstanding and unvested awardsin each period (in thousands):

 

8

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|                                                                                                                         |   | **Three Months Ended  June 30,** |   | **Six Months Ended  June 30,** |   |
|------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------|--------|-------------------------------------|--------|
|                                                                                                                         |   | **2003**                              |   | **2002**                            |   | **2003** |   | **2002** |   |
|                                                                                                                         |   |                                  |   |                                |   |   |   |   |   |
| Net loss, as reported                                                                                                        |   | $                                     | (826   | )                                   | $      | (4,221 | ) | $ | (1,681 | ) | $ | (9,905 | ) |
| Add stock-based employee compensation expenses  included in reported net loss, net of tax                                    |   | —                                |   | —                              |   | — |   | 5 |   |
| Deduct total stock-based employee compensation  expense determined under fair-value-based method for all rewards, net of tax |   | $                                     | (1,058 | )                                   | $      | (1,488 | ) | $ | (2,201 | ) | $ | (3,083 | ) |
| Pro forma net loss                                                                                                           |   | $                                     | (1,884 | )                                   | $      | (5,709 | ) | $ | (3,882 | ) | $ | (12,988 | ) |
| Basic and diluted net loss per share:                                                                                        |   |                                  |   |                                |   |   |   |   |   |
| As reported                                                                                                                  |   | $                                     | (0.03  | )                                   | $      | (0.17 | ) | $ | (0.07 | ) | $ | (0.40 | ) |
| Pro forma                                                                                                                    |   | $                                     | (0.07  | )                                   | $      | (0.24 | ) | $ | (0.15 | ) | $ | (0.54 | ) |

 

(i) New Accounting Policies

 

In November 2002, the EITF reached a consensus on Issue No. 00-21(“EITF 00-21”), *Revenue Arrangements withMultiple Deliverables*. EITF 00-21 addresses certain aspects of theaccounting by a vendor for arrangements under which the vendor will performmultiple revenue generating activities. EITF 00-21 will be effective for periods beginning after June 15,2003. The adoption of EITF 00-21 is not expected to have a material impact onClick2learn’s financial position and results of operations.

 

In January 2003, theFASB issued Interpretation No. 46 (“FIN 46”), *Consolidationof Variable Interest Entities, an Interpretation of ARB No. 51.*  FIN 46 addresses the consolidation bybusiness enterprises of variable interest entities as defined in FIN 46.  FIN 46 applies immediately to variableinterests in variable interest entities created after January 31, 2003,and to variable interests in variable interest entities obtained afterJanuary 31, 2003.  For publicenterprises with a variable interest in a variable interest entity createdbefore February 1, 2003, FIN 46 applies to that enterprise no later thanthe beginning of the first interim or annual reporting period beginning afterJune 15, 2003. The application of FIN 46 is not expected to have amaterial effect on Click2learn’s financial statements.  FIN 46 requires certain disclosures in financialstatements issued after January 31, 2003 if it is reasonably possible thatClick2learn will consolidate or disclose information about variable interestentities when the Interpretation becomes effective. Click2learn has no variableinterest entities as of June 30, 2003.

 

In April 2003, theFASB issued SFAS No. 149 (“SFAS No. 149”), *Amendmentof Statement 133 on Derivative Instruments and Hedging Activities*.  SFAS No. 149 amends and clarifies financialaccounting and reporting for derivative instruments, including certainderivative instruments embedded in other contracts (collectively referred to asderivatives) and for hedging activities under SFAS No. 133.  SFAS No. 149 is effective for contractsentered into or modified after June 30, 2003, and hedging relationsdesignated after June 30, 2003, except for those provisions of SFAS No.149 which relate to SFAS No. 133 implementation issues that have been effectivefor fiscal quarters that began prior to June 15, 2003.  For those issues, the provisions that arecurrently in effect should continue to be applied in accordance with theirrespective effective dates.  Inaddition, certain provisions of SFAS No. 149, which relate to forward purchasesor sales of when-issued securities or other securities that do not yet exist,should be applied to both existing contracts and new contracts entered intoafter June 30, 2003.  The adoptionof SFAS No. 149 is not expected to have a material effect on Click2learn’sfinancial statements.

 

In May 2003, theFASB issued SFAS No. 150 (“SFAS No. 150”), *Accountingfor Certain Instruments with Characteristics of both Liabilities and Equity*.  SFAS No. 150 establishes standards for howan issuer classifies and measures certain financial instruments withcharacteristics of both liabilities and equity.  SFAS No. 150 requires that an issuer classify a financialinstrument that is within the scope of SFAS No. 150 as a liability.  SFAS No. 150 is effective for financialinstruments entered into or modified

 

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after May 31, 2003, and otherwise is effective for Click2learnbeginning September 1, 2003.  Theadoption of SFAS No. 150 is not expected to have a material effect onClick2learn’s financial statements.

 

#### **NOTE  2: DISCONTINUED OPERATIONS**

 

During January 2002, Click2learn sold certain assets of itscontent development business, including equipment and a customer list to NIIT(USA), Inc. (“NIIT”), the U.S. operations of NIIT Limited, a global customsoftware development firm, under an Asset Purchase agreement for $1 million,resulting in a gain of $927,000 based on the book value of those assets. As aresult of the transaction with NIIT, Click2learn significantly reduced theheadcount of its custom content development business and closed certainfacilities.  During the third quarter of2002, Click2learn completed the discontinuation of its remaining custom contentdevelopment business by early termination of its contract to develop contentfor the Washington Army National Guard. As part of the negotiation to terminatethe contract, Click2learn agreed to forego the collection of $4.5 million inaccounts receivable.  Results related toits custom content development business for the year ended December 31,2002 and prior years have been reclassified as income (loss) from discontinuedoperations.

 

Summary operating results of the discontinued operations were asfollows (in thousands):

 
|                              |   | **For the Three  Months Ended  June 30,  2002** |   | **For the Six  Months Ended  June 30,  2002** |   |
|-----------------------------------|--------|------------------------------------------------------|--------|----------------------------------------------------|--------|
| Revenues                          |   | $                                                    | 27     |                                               | $      | 248 |   |
| Cost of revenues                  |   | $                                                    | (683   | )                                                  | $      | (2,243 | ) |
| Operating expenses                |   | $                                                    | — |                                               | $      | (1,583 | ) |
| Other income                      |   | $                                                    | — |                                               | $      | 927 |   |
| Loss from discontinued operations |   | $                                                    | (656   | )                                                  | $      | (2,651 | ) |

 

**NOTE3:  BANK CREDIT FACILITY**

 

In December 2002, Click2learnconsolidated its existing $4 million working capital line of credit and $1million term loan facility with Silicon Valley Bank into a new $10 millionworking capital line.  Under the newfacility Click2learn will continue to repay the remaining balance of the termloan in accordance with the original terms (monthly payments of  $41,666.67 plus interest ending October 1, 2003), but the unpaid balanceof the term loan will not be available under the line of credit.  The term loan and the working capital linewill bear interest at the greater of Silicon Valley Bank prime rate plus 2.25%or 7.0% and have minimum monthly interest of $8,500 per month regardless of theloan balances.

 

The credit facility is collateralized by asecurity interest in all of Click2learn’s assets.  Covenants in the loan agreements include restrictions onClick2learn’s ability to pay dividends or make other distributions, makeacquisitions or investments, merge or consolidate with others or dispose ofassets, as well as financial covenants limiting the amount of net losses duringany three month period and requiring Click2learn to maintain certain levels ofminimum tangible net worth.  If notrenewed, the working capital line terminates and any advances made are due onDecember 6, 2004.

 

Under the working capitalline of credit, the principal amount of $2,757,000 was outstanding as ofJune 30, 2003.  Borrowingsoutstanding under the term loan were $167,000 at June 30, 2003 all ofwhich is repayable in 2003.  As ofJune 30, 2003, Click2learn was in compliance with the loan’s covenants.** **Click2learn has a note payable of which $408,500 is current and reportedas short term debt and $222,000 is reported as long-term debt.  The total amount due under this note payablewill be paid off during the three month period ended September 30,2003.  Aggregate short-term debtof $3.2 million at June 30, 2003 is presented net of debt discount of$133,000 attributable to the issuance of common stock warrants.

 

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**NOTE 4:  GUARANTEES**

 

Click2learnadopted FIN 45 during the quarter ended December 31, 2002.  In the ordinary course of business,Click2learn is not subject to potential obligations under guarantees that fallwithin the scope of FIN 45 except for standard indemnification and warrantyprovisions that are contained within many of our customer license and serviceagreements, and give rise only to the disclosure requirements prescribed by FIN45*.*

* *

Indemnificationand warranty provisions contained within our customer license and serviceagreements are generally consistent with those prevalent in our industry.  The duration of our product warrantiesgenerally does not exceed 90 days following delivery of our products.  We have not incurred significant obligationsunder customer indemnification or warranty provision historically and do notexpect to incur significant obligations in the future.  Accordingly, we do not maintain accruals forpotential customer indemnification or warranty-related obligations.

 

**NOTE 5:  SEGMENT INFORMATION**

 

Click2learn’s internalreporting includes the three reportable segments:  Platforms, Tools, and Content Services.  Platforms revenue includes software licenses, subscription and hostingfees, implementation, customization, consulting, training and support relatedto the Aspen suite, the Ingenium learning management system, which is theprecursor product to the Aspen Learning Management Server, and the e-LearningNetwork, which is no longer offered to new customers. Tools revenue includessoftware licenses, technical support and training related to the ToolBook lineof products.  Content Services revenueincludes the placement of Click2learn personnel at customer sites on a time andmaterial basis, the resale of third party off the shelf training content and licenseand hosting fees for our Rapid e-Learning Development System, which is nolonger offered to new customers.

 

Click2learn’s operating committee, whichincludes its Chief Executive Officer and Chief Financial Officer, has beenidentified as the Chief Operating Decision Maker (CODM) as it assesses theperformance of the business units and decides how to allocate resources to thebusiness units.  Segment income is themeasure of profit and loss that the CODM uses to assess performance and makedecisions.  Segment income representsrevenue less cost of revenue incurred within the operating segments aspresented in Click2learn’s consolidated statements of operations.  Click2learn does not allocate operatingexpenses including research and development, sales and marketing, general andadministrative, or amortization of goodwill to its operating segments.  In addition, other income (expense) are alsonot allocated to operating segments.

 

There is nointersegment revenue.  Click2learn’sCODM does not review total assets or depreciation and amortization by operatingsegment.  The accounting policies forreported segments are the same as Click2learn as a whole.

 

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Revenues by geographic region which are basedon the location of the customers are as follows (in thousands):

 
|     |   | **For the  Three  Months Ended  June 30,** |   | **For the  Six  Months Ended  June 30,** |   |
|----------|--------|-------------------------------------------------|--------|-----------------------------------------------|--------|
|     |   | **2003**                                        |   | **2002**                                      |   | **2003** |   | **2002** |   |
| Revenue: |   |                                            |   |                                          |   |   |   |   |   |
| US       |   | $                                               | 6,809  |                                          | $      | 6,916 |   | $ | 14,005 |   | $ | 13,434 |   |
| UK       |   | 835                                             |   | 111                                           |   | 1,224 |   | 480 |   |
| Other    |   | 485                                             |   | 575                                           |   | 900 |   | 998 |   |
|     |   | $                                               | 8,129  |                                          | $      | 7,602 |   | $ | 16,129 |   | $ | 14,912 |   |

 

Long-lived assets by geographic location are as follows (in thousands):

 
|              |   | **June 30,  2003** |   | **December 31,  2002** |   |
|-------------------|--------|-------------------------|--------|-----------------------------|--------|
| Long-lived assets |   |                    |   |                        |   |
| US                |   | $                       | 7,773  |                        | $      | 8,596 |   |
| Other             |   | 228                     |   | 131                         |   |
|              |   | $                       | 8,001  |                        | $      | 8,727 |   |

 

Long-lived assets represent property, plant,and equipment, goodwill and other intangible assets, net of accumulateddepreciation and amortization.

 

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**Item 2.****  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

*This Quarterly Report includes“forward-looking statements” within the meaning of the Private SecuritiesLitigation Reform Act of 1995. This Act provides a “safe harbor” forforward-looking statements to encourage companies to provide prospectiveinformation about themselves so long as they identify these statements asforward-looking and provide meaningful cautionary statements identifyingimportant factors that could cause actual results to differ from the projectedresults. All statements other than statements of historical fact we make inthis Quarterly Report are forward-looking. Such forward-looking statementsinvolve risks and uncertainties, including, among other things, statements regardingour anticipated costs and expenses and revenue mix. Such forward-lookingstatements include, among others, those statements including the words“expect”, “anticipate”, “intend”, “believe” and similar language. Our actualresults may differ significantly from those projected in the forward-lookingstatements. Factors that might cause or contribute to such differences include,but are not limited to those discussed in the section “Management’s Discussionand Analysis of Financial Condition and Results of Operations — Factors ThatMay Affect Future Results of Operations.” You are cautioned not to placeundue reliance on the forward-looking statements, which speak only as of thedate of this Quarterly Report on Form 10-Q. We undertake no obligation to publiclyrelease any revisions to the forward-looking statements or reflect events orcircumstances after the date of this document.*

 

**Overview**

 

We are a leading developer and provider ofenterprise learning solutions for companies, government agencies and educationalinstitutions. We design, develop, market, license and support an integratedsuite of enterprise software products and related services that allow ourcustomers to cost-effectively create, personalize and manage the delivery oflearning and knowledge content. Our flagship product, the Aspen EnterpriseProductivity Suite, combines collaborative content development, comprehensivelearning management and virtual classroom systems into a single, integratedproduct suite with a unified architecture and user experience. We provide ourproducts and services to customers across a broad range of industries includingfinancial services, accounting, healthcare, insurance, technology,manufacturing, telecommunications, transportation, utilities, government andeducation.

 

We report revenue in three separatecategories related to the different components of our business:

 

•                        Platforms revenue includes software licenses,subscription and hosting fees, implementation, customization, consulting,training and support related to the Aspen suite, our Ingenium learningmanagement system, which is the precursor product to the Aspen LearningManagement Server, and our e-Learning Network, which is no longer offered tonew customers.

•                        Tools revenue includes software licenses,technical support and training related to our ToolBook line of products.

•                        Content Services revenue includes the placementof Click2learn personnel at customer sites on a time and material basis, theresale of third party off the shelf training content and license and hostingfees for our Rapid e-Learning Development System, which is no longer offered tonew customers.  During 2002 wediscontinued our custom content development business, which had been the primarysource of revenue from Content Services in prior years.  Prior year’s revenue and expenses for thisportion of the business have been reclassified as income or loss fromdiscontinued operations.

 

**CriticalAccounting Policies and Estimates**

 

Our critical accounting policies andestimates are as follows:

 

•                       Revenue recognition

•                       Estimating allowances for sales returns and theallowance for doubtful accounts

 

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•                       Valuation of goodwill

•                       Valuation of long-lived assets

 

*Revenue Recognition.*We recognize revenue pursuant to the requirementsof Statement of Position No. 97-2, *SoftwareRevenue Recognition* (“SOP 97-2”), as amended by Statement ofPosition No. 98-9, *Software RevenueRecognition with Respect to Certain Arrangements.* Under SOP 97-2,revenue attributable to an element in a customer arrangement is recognized whenpersuasive evidence of an arrangement exists and delivery has occurred,provided the fee is fixed or determinable, collectibility is probable and thearrangement does not require significant customization of the software.

 

For all sales, we use either a bindingpurchase order or signed agreement, depending on the nature of the transaction,as evidence of an arrangement. Sales through our significant resellers areevidenced by a master agreement governing the relationship.

 

For software license fees in single elementarrangements and multiple element arrangements, which do not includecustomization or consulting services, delivery typically is deemed to occurwhen the product is shipped to customers.

 

At the time of each transaction, we assesswhether the fee associated with our revenue is fixed and determinable andwhether or not collection is probable. We assess whether the fee is fixed anddeterminable based on the payment terms associated with the transaction. If asignificant portion of a fee is due after our normal payment terms, based upona variable matrix such as a minimum level of distribution or subject to refund(other than refunds for warranty claims or our uncured defaults), we accountfor the fee as not being fixed and determinable. In these cases, we deferrevenue and recognize it when it becomes due and payable.

 

We assess the probability of collection basedon a number of factors, including past transaction history with the customerand the current financial condition of the customer. We do not requestcollateral from our customers. If we determine at the time of the transactionthat collection of a fee is not probable, we defer revenue until payment isreceived.

 

For multiple element arrangements, whencompany-specific objective evidence of fair value exists for all of theundelivered elements of the arrangement, but does not exist for one or more ofthe delivered elements in the arrangement, we recognize revenue under the residualmethod. Under the residual method, at the outset of the arrangement with acustomer, we defer revenue for the fair value of its undelivered elements suchas consulting services and product support and upgrades, and recognize therevenue for the remainder of the arrangement fee attributable to the elementsinitially delivered, such as software licenses, when the criteria in SOP 97-2have been met. Company-specific objective evidence is established for supportand upgrades of standard products for which no installation or customization isrequired based upon the amounts we charge when support and upgrades are soldseparately. For multiple element arrangements involving installation orcustomization, company-specific objective evidence is established for supportand maintenance arrangements if our customers have an optional annual renewalrate specified in the arrangement and the rate is substantive. Company-specificobjective evidence is established for consulting and installation servicesbased on the hourly rates we charge for our employees when they are performingthese services provided we have the ability to accurately estimate the hoursrequired to complete a project based upon our experience with similar projects.

 

Professional services revenue is recognizedfrom fixed price contracts as services are provided or by using thepercentage-of-completion method of accounting, based on the ratio of laborcosts incurred to the total estimated project cost, for individual fixed-pricecontracts. Provisions for any estimated losses on uncompleted contracts aremade in the period in which such losses become evident. Professional servicesrevenue from time and materials contracts and training services is recognizedas revenue as services are performed.

 

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We recognize revenue from non-refundableminimum royalty agreements from distributors or resellers upon delivery ofproduct to the distributor or reseller, provided no significant obligationsremain outstanding and the conditions of SOP 97-2 have been met.  If minimum royalties are exceeded, theadditional royalties are recognized as revenue when earned, based on thecontractual reporting obligations.

 

Revenue from subscription licenses, hostingagreements and support agreements is recognized on a straight-line basis overthe life of the contract.

 

*Allowances for Sales Returns and DoubtfulAccounts.*Thepreparation of financial statements requires us to make estimates andassumptions that affect the reported amount of assets and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenue and expenses during the reported period.Specifically, we must make estimates of future product returns related to currentperiod product revenue. We analyze historical returns, current economic trends,and changes in customer demand and acceptance of our products when evaluatingthe adequacy of the sales returns and other allowances. Significant judgmentsand estimates must be made and used in connection with establishing reservesfor sales returns and the allowance for doubtful accounts in any accountingperiod. Material differences may result in the amount and timing of our revenuefor any period if we made different judgments or utilized different estimates.Similarly, we must make estimates of the uncollectability of our accountsreceivable. We specifically analyze accounts receivable greater than 90 daysand analyze historical bad debts, customer concentrations, customercredit-worthiness and current economic trends when evaluating the adequacy ofthe allowance for doubtful accounts.

 

*Valuation of Goodwill.*We assess the impairment of goodwill on an annualbasis or whenever events or changes in circumstances indicate the fair value ofa reporting unit to which goodwill relates is less than its carrying value.Factors we consider important which could trigger an impairment review includepoor economic performance relative to expected historical or projected futureoperating results, significant negative industry, economic or company specifictrends and changes in the manner of our use of the assets or the plans for ourbusiness. If we were to determine that the fair value of a reporting unit wasless than its carrying value, including goodwill based upon the annual test orthe existence of one or more of the above indicators of impairment, then wewould measure impairment based on a comparison of the implied fair value ofreporting unit goodwill with the carrying amount of goodwill. The implied fairvalue of goodwill is determined by allocating the fair value of a reportingunit to its assets (recognized and unrecognized) and liabilities in a mannersimilar to a purchase price allocation. The residual fair value after thisallocation is the implied fair value of reporting unit goodwill. To the extentthe carrying amount of reporting unit goodwill is greater than the implied fairvalue of reporting unit goodwill, we would record an impairment charge for thedifference.

 

*Valuation of Long Lived Assets.*  SFAS 144 provides a single accounting modelfor disposal of long-lived assets. SFAS 144 also changes the criteria forclassifying an asset as held for sale and broadens the scope of businesses tobe disposed of that qualify for reporting as discontinued operations andchanges the timing of recognizing losses on such operations. We adopted SFAS144 on January 1, 2002.  Theadoption of SFAS 144 did not affect our consolidated financial position orresults of operations as of January 1, 2002.  The broadened definition of discontinued operations with SFAS 144has affected the presentation and disclosure of our results of operations forthe year ended 2002 and prior years presented for comparison. In accordancewith SFAS 144, we review long-lived assets, such as property, plant, andequipment, and purchased intangibles subject to amortization, for impairmentwhenever events or changes in circumstances indicate that the carrying amountof an asset may not be recoverable. We measure recoverability of assets to beheld and used by comparing the carrying amount of an asset to estimatedundiscounted future cash flows expected to be generated by the asset. If thecarrying amount of an asset exceeds its estimated future cash flows, we recognizean impairment charge as the amount by which the carrying amount of the assetexceeds the fair value of the asset. Assets to be disposed of would beseparately presented in the balance sheet and reported at the lower of thecarrying amount or fair value less costs to sell, and are no longerdepreciated.  The assets and liabilitiesof a disposal group classified as held for sale would be presented separatelyin the appropriate asset and liability sections of the balance sheet.

 

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# **Results of Operations for the Three and Six MonthsEnded June 30, 2003 Compared to the Three and Six Months EndedJune 30, 2002**

 

In accordancewith Statement of Financial Accounting Standards No. 144, *Accounting for the Impairment and Disposal ofLong-lived Assets*, the financial statements and management’sdiscussion and analysis present results from continuing operations with revenueand expenses related to our discontinued custom content development business asloss from discontinued operations.  See“Loss from Discontinued Operations” for additional information regarding thediscontinuance of the custom content development business and the amount ofrevenue and costs that have been reclassified to loss from discontinuedoperations.

 

*Revenue. *For the three and six-month periods endedJune 30, 2003 total revenue increased 7% and 8% to $8.1 million and $16.1million as compared to $7.6 million and $14.9 million for the same periodsended June 30, 2002.  The increasein revenue is attributed to revenue growth from the Platforms category offsetby declining revenue from the Tools and Content Services categories.

 

Platforms revenue grew 25% and 23% to $6.9 million and $13.4 millionfor the three and six-month periods ended June 30, 2003 as compared to$5.5 million and $10.9 million for the comparable periods ended June 30,2002.  This growth is attributable toexisting clients purchasing additional Aspen licenses or services as well asnew clients purchasing initial Aspen licenses and services.  We believe that future growth in totalrevenue is dependant on continuing to increase Platforms revenue.

 

Tools revenue declined 37% and 38% to $784,000 and $1.6 million for thethree and six-month periods ended June 30, 2003 as compared to $1.2 millionand $2.5 million for the periods ended June 30, 2002.  Although we recently increased our researchand development investment in the ToolBook line to create a new versionrelease, we expect Tools revenue to remain at current levels or to decline overthe next six months.

 

Content Services revenue declined 44% and 22% to $474,000 and $1.1million for the three and six-month periods ended June 30, 2003 ascompared to $848,000 and $1.5 million for the periods ended June 30,2002.  Current Content Services revenueis derived primarily from the placement of temporary personnel at our clients’locations on an hourly basis.  Due tothe economic downturn, demand for temporary labor resources is down.  We believe that Content Services revenuewill remain at current levels or decline over the next six months.

 

*Cost of Revenue*.  For the three and six-month periods endedJune 30, 2003 total cost of revenue decreased 15% and 14% to $2.1 millionand $4.3 million as compared to $2.4 million and $5.0 million for the sameperiods ended June 30, 2002.  Thedecrease is primarily due to lower costs as a percentage of revenue related toour Platform revenue and declines in Tools and Content Services costs as aresult of lower revenue over these periods.

 

Platform cost of revenue was unchanged at $1.5 million and $3.1 millionfor the three and six-month periods ended June 30, 2003 and June 30,2002.  Platform cost of revenue as apercentage of Platform revenue was 21% and 23% for the three and six-monthperiods ended June 30, 2003 down from 27% and 28% for the same periodsended June 30, 2002.  The declineas a percentage of revenue is due to reduced labor costs on the servicesportion of Platform revenue resulting from performing some of this work usingour operations in Hyderabad, India where comparable labor rates are lower.

 

Tools cost of revenue declined 53% and 62% to $133,000 and $258,000 forthe three and six-month periods ended June 30, 2003 as compared to$287,000 and $682,000 for the same period ended June 30, 2002.  The decline is a result of lower Toolsrevenue.

 

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Content Services cost of revenue declined 32% and 22% to $445,000 and$1 million for the three and six-month periods ended June 30, 2003 ascompared to $652,000 and $1.3 million for the same period ended June 30,2002.  The decline is a result of lowerContent Services revenue.

 

**Operating Expenses**

 

*Research and Development*.  For the three and six-month periods endedJune 30, 2003 total cost declined 20% and 28% to $1.9 million and $3.4million as compared to $2.4 million and $4.7 million for the same periods endedJune 30, 2002.  The decline is aresult of cost cutting measures taken in the second half of 2002 that resultedin lower headcount in the United States and the establishment of research anddevelopment operations in Hyderabad, India where labor costs are lower than inthe United States. We anticipate that research and development costs willincrease during 2003 as a result of an increase in amortization costs relatedto acquired technology and increased staffing necessary for upcoming releasesof the Aspen platform.

 

*Sales and Marketing.* For the three and six-month periods endedJune 30, 2003 total cost declined 28% and 23% to $3.5 million and $7.2 millionas compared to $4.8 million and $9.3 million for the same periods endedJune 30, 2002.  The decline is aresult of cost cutting measures taken in the second half of 2002 that resultedin lower sales and marketing headcount aswell as reduced advertising costs over the comparable periods.

 

*General and Administrative.* For the three and six-month periods endedJune 30, 2003 total cost declined 2% and 9% to $1.4 million and $2.8million as compared to $1.4 million and $3.0 million for the same periods endedJune 30, 2002.  The decline is aresult of lower headcount in 2003.

 

*Other Income (Expense).*  For the three and six-months endedJune 30, 2003 other expenses were $46,000 and $93,000.  These amounts are primarily interest onborrowing from Silicon Valley Bank.  For the same periods ended June 30,2002 the company did not have any material other income or expenses.

 

*Equity inLosses of Affiliate*.  Losses from affiliates relate to our jointventure with Softbank in Japan, Click2learn Japan KK.  We use the equity method of accounting whereby we record ourownership portion of the joint ventures net income or loss.  For the three and six month periods endedJune 30, 2003 our losses from affiliates were $25,000 and  $50,000 compared to $75,000 and $150,000 forthe periods ended June 30, 2002.

 

*Loss fromDiscontinued Operations*.  In 2003 we have not had lossesfrom discontinued operations.  For thethree and six month periods ended June 30, 2002 losses from thediscontinuation of our custom development business were $656,000 and $2.7million respectively.

 

**RecentAccounting Pronouncements**

 

In November 2002,the EITF reached a consensus on Issue No. 00-21 (“EITF 00-21”), *Revenue Arrangements with Multiple Deliverables*.  EITF 00-21 addresses certain aspects of theaccounting by a vendor for arrangements under which the vendor will performmultiple revenue generating activities. EITF 00-21 will be effective for periods beginning after June 15,2003.  The adoption of EITF 00-21 is notexpected to have a material impact on Click2learn’s financial position andresults of operations.

 

In January 2003, theFASB issued Interpretation No. 46 (“FIN 46”), *Consolidationof Variable Interest Entities, an Interpretation of ARB No. 51.*  FIN 46 addresses the consolidation by businessenterprises of variable interest entities as defined in FIN 46.  FIN 46 applies immediately to variableinterests in variable interest entities created after January 31, 2003,and to variable interests in variable interest entities obtained after January 31,2003.  For public enterprises with avariable interest in a variable interest entity created before February 1,2003, FIN 46 applies to that enterprise no later than the beginning of thefirst interim or annual reporting period beginning after June 15, 2003.The application of FIN 46 is

 

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not expected to have a material effect on our financialstatements.  FIN 46 requires certaindisclosures in our financial statements issued after January 31, 2003 ifit is reasonably possible that we will consolidate or disclose informationabout variable interest entities when the Interpretation becomeseffective.  We have no variable interestentities as of March 31, 2003.

 

In April 2003, theFASB issued SFAS No. 149 (“SFAS No. 149”), *Amendmentof Statement 133 on Derivative Instruments and Hedging Activities*.  SFAS No. 149 amends and clarifies financialaccounting and reporting for derivative instruments, including certainderivative instruments embedded in other contracts (collectively referred to asderivatives) and for hedging activities under SFAS No. 133.  SFAS No. 149 is effective for contractsentered into or modified after June 30, 2003, and hedging relationsdesignated after June 30, 2003, except for those provisions of SFAS No.149 which relate to SFAS No. 133 implementation issues that have been effectivefor fiscal quarters that began prior to June 15, 2003.  For those issues, the provisions that arecurrently in effect should continue to be applied in accordance with theirrespective effective dates.  Inaddition, certain provisions of SFAS No. 149, which relate to forward purchasesor sales of when-issued securities or other securities that do not yet exist, shouldbe applied to both existing contracts and new contracts entered into afterJune 30, 2003.  The adoption ofSFAS No. 149 is not expected to have a material effect on Click2learn’sfinancial statements.

 

In May 2003, theFASB issued SFAS No. 150 (“SFAS No. 150”), *Accountingfor Certain Instruments with Characteristics of both Liabilities and Equity*.  SFAS No. 150 establishes standards for howan issuer classifies and measures certain financial instruments withcharacteristics of both liabilities and equity.  SFAS No. 150 requires that an issuer classify a financialinstrument that is within the scope of SFAS No. 150 as a liability.  SFAS No. 150 is effective for financialinstruments entered into or modified after May 31, 2003, and otherwise iseffective for Click2learn beginning September 1, 2003.  The adoption of SFAS No. 150 is not expectedto have a material effect on Click2learn’s financial statements.

 

**Liquidity and Capital Resources**

 

At June 30, 2003, our principal source ofliquidity was $15.8 million of cash and $9.5 million of accounts receivable, upfrom $3.6 million of cash and down from $10.8 million of accounts receivable onDecember 31, 2002.  The change in cashis due primarily to the sale of common stock and warrants during June thatresulted in net cash proceeds of approximately $11.9 million.  The change in accounts receivable is dueprimarily to improved collection efforts. We believe our risk on current Platform-related receivables is low giventhe general financial strength of our customers.  As of June 30, 2003, we had one significant account, a receivableof approximately $500,000 from an international customer, over 90 days past duefor which we believe collectibility is at risk.  We increased our bad debt reserve for this account in 2002.  At June 30, 2003 we had no other significantcollectibility or billing problems with any major customers or classes ofcustomers.

 

Although we have not made any significantchanges in our payment terms, as a result of the discontinuance of our customcontent development business we are able to collect more quickly on ourreceivables generally than in prior periods, when a significant portion of ourrevenue was from custom content development contracts.  This is because a typical custom developmentcontract was invoiced on the achievement of contract milestones, althoughrevenue was recognized using the percentage of completion method as theservices were performed.  As a result,there was often significant time elapsed between the performance of theservices and invoicing the client.  Thus,the receivables from such contracts remained uncollected for longer periodsthan those from software licenses or other services.  While we expect to be able to collect on our receivables morequickly going forward, we may offer extended payment terms to customers incertain circumstances from time to time. To the extent that we offer such extended payment terms, they willresult in a longer collection period for accounts receivable and slower cashinflows from operations.

 

AtJune 30, 2003, we had cash and cash equivalents totaling $15.8 million, upfrom $3.6 million at December 31, 2002. The increase in cash was primarily the result of positive cash flowsfrom operations during the six month period ended June 30, 2003 and netcash proceeds of approximately $11.9 million from the

 

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sale of stock and warrants inJune.  Based on our positive operatingcash flows year-to-date and our current cash balance, we anticipate that ourcash and cash equivalents will be sufficient to meet our working capital needsand capital expenditures for at least the next 12 months.  However, we will continue to monitor our cash and liquidity and will seekadditional financing or make additional expense reductions if it becomes required.

 

Net cash used in investing activities was $482,000 in the six monthsended June 30, 2003.  Net cash usedin investing activities was primarily used for purchases of equipment. As ofJune 30, 2003, we had no material commitments for capital expenditures andhad commitments under non-cancelable operating leases with terms in excess ofone year of $5.8 million through 2008.

 

Cash provided by financing activities was $12.4 million in the sixmonths ended June 30, 2003, resulting primarily from draws against theSilicon Valley Bank credit facility, net of payments on debt, of approximately$300,000; net cash proceeds of approximately $11.9 million from the sale ofcommon stock and warrants in June; and approximately $200,000 received frompurchases under our Employee Stock Purchase Plan. Cash from borrowings wasapproximately $13.6 million, while cash used for payments on debt was $13.3million in the six months ended June 30, 2003.

 

In December 2002 we consolidated our existing $4 million workingcapital line of credit and $1 million term loan facility with Silicon ValleyBank into a new $10 million working capital line.  Under the new facility we will continue to repay the remainingbalance of the term loan in accordance with the original terms (monthlypayments of $41,666.67 plusinterest ending October 1, 2003), and the unpaid balance of the term loanwill not be available for new loans under the line of credit.  The term loan and the working capital linewill bear interest at the greater of Silicon Valley Bank prime rate plus 2.25%or 7.0% and have minimum monthly interest of $8,500 per month regardless of theloan balances.  The credit facility iscollateralized by a security interest in all of our assets.  Covenants in the loan agreements include restrictionson our ability to pay dividends or make other distributions, make acquisitionsor investments, merge or consolidate with others or dispose of assets, as wellas financial covenants limiting the amount of net losses during any three-monthperiod and requiring us to maintain certain levels of minimum tangible networth.  The failure to meet thosecovenants could prevent us from accessing the working capital line and resultin the acceleration of any balances under the working capital line and term loan.If not renewed the working capital line terminates and any advances made aredue on December 6, 2004.  AtJune 30, 2003, we had a balance of $167,000 on the term loan facility and$2.6 million on the working capital line, net of debt discount of $133,000.

 

The amount available under the workingcapital line of credit as of June 30, 2003 is 65% of our eligible accountsreceivable.  This percentage may beadjusted up or down based on a quarterly analysis by the bank.  Eligible accounts receivable are thoseaccounts receivable that the bank determines in its good faith businessjudgment to include in the borrowing base. Certain accounts, such as accounts that are over 90 days past due,unbilled receivables and foreign or government accounts, are not currentlyeligible.  Although we may take steps toinclude foreign and government accounts in our borrowing base, there isadditional cost involved and we have not deemed it necessary to do so to date.  As a result of this limitation on eligibleaccounts, the entire $10 million is not currently available to us under theline of credit and the entire $10 million may not become available in thefuture.  Moreover, because the amountavailable for borrowing under our agreement is based on our eligible accountsreceivable, we may from time to time become over-advanced under the line ofcredit if our eligible accounts receivable decrease, either because they havebeen collected but not applied against the existing obligations in the case ofthe term loan or because they have become ineligible under the terms of theagreement.  In such a case we may berequired to immediately repay a portion of the amount borrowed sufficient tobring the total amount owed to no more than the total availability under theloan facility.

 

Click2learn has a note payable of which$408,500 is current and reported as short-term debt and $222,000 is reported aslong-term debt.  The total amount dueunder this note payable will be paid off during the three month period endedSeptember 30, 2003.

 

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Our long-termliquidity will be affected by numerous factors, including demand for our Aspenplatform, the level and timing of revenue, the collection of our receivables,the availability of our line of credit, the extent to which we raise additionalfunds from investors, the timing and extent to which we invest in newtechnology, the expenses of sales and marketing and new product development,the extent to which competitors are successful in developing their own productsand services and increasing their own market share, acquisitions of businessesor technologies and other factors.  Tothe extent that our existing capital resources are insufficient to fund our activities,we may need to raise additional funds. Such additional funding, if needed, may not be available on attractiveterms or at all.  If adequate funds arenot available on acceptable terms, we maybe required to make further expense reductions, which could significantlyrestrict our operations and limit our ability to enhance our products, fundexpansion, respond to competitive pressures or take advantage of businessopportunities.

 

Our contractual commitments at June 30,2003 are substantially similar to those at December 31, 2002 disclosed inour annual report on Form 10-K.

 

**FactorsThat May Affect Future Results of Operations**

 

*Ourquarterly operating results are uncertain and may fluctuate significantly,**which could negatively affect the value of yourinvestment.*

 

Our operating results are difficult topredict accurately and have varied significantly from quarter to quarter andare likely to continue to fluctuate as a result of a variety of factors, manyof which we cannot control. Factors that may adversely affect our quarterlyoperating results include:

 

•                       the size and timing of product orders and thetiming and execution of professional services engagements;

•                       the mix of revenue from products and services;

•                       the mix of products sold;

•                       the ability to meet client project milestones;

•                       the market acceptance of our products andservices;

•                       ourability to develop and market new or enhanced products and services in a timelymanner and the market acceptance of these products and services;

•                       the timing of revenue and expense recognition;and

•                       recognition of impairment of existing assets.

 

Our future revenue is difficult to predictand we may not be able to adjust spending in response to revenue shortfalls.Our limited operating history with our current enterprise learning solutionsand the emerging nature of the enterprise learning market make prediction offuture revenue and expenses difficult. Expense levels are based, in part, onexpectations as to future revenue and largely are fixed in the short term.  If we are unable to predict future revenueaccurately, we may be unable to adjust spending in a timely manner tocompensate for any unexpected revenue shortfall.

 

*Ourbusiness may not generate the cash needed to finance our**operations, and for that and other reasons we mayneed additional financing in**the future, which we may be unable to obtain.*

 

Although our business generated positive cashflow from operations over the first six months of 2003 and we expect togenerate positive cash flow from operations at currently anticipated revenuelevels and revenue mix during the second half of 2003, we may not achieveexpected revenue levels or revenue mix and our business may not maintainpositive cash flow.  If our businessdoes not generate the cash needed to finance our operations, we may need to obtainadditional financing or take steps to restrict our operations in order toconserve existing cash.  In addition,poor financial results or unanticipated expenses could give rise to additionalfinancing requirements. We may be unable to obtain financing on terms favorableto us, or at all.  If we need to obtainfinancing and adequate funds are not available or are not available onacceptable terms, we may be required to make further expense reductions, whichcould

 

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significantlyrestrict our operations and limit our ability to enhance our products, fundexpansion, respond to competitive pressures or take advantage of businessopportunities.

 

*Adeterioration of general economic conditions may materially and adversely**affect our business.*

 

Our revenue is subject tofluctuation as a result of general economic conditions and overall spending inthe technology and enterprise software sectors. A significant portion of ourrevenue is derived from the sale of products and services to large companies orgovernment agencies, which historically have reduced their expenditures forenterprise software applications during economic downturns. In recent quarters,our sales force has experienced increased delays, cancellations or reductionsin scope of sales opportunities as a result of the downturn in theeconomy.  Further war or acts ofterrorism may cause the economy to weaken further, which could result inorganizations further delaying, canceling, or reducing capital expendituresgenerally and spending on enterprise software applications in particular.  Such delays, cancellations or reductionscould adversely affect our business.

 

*Wehave a history of losses and may have continued losses in the future.*

 

We incurred a net loss ofapproximately $1.7 million for the six months ended June 30, 2003.  As of June 30, 2003, our accumulateddeficit was $231.7 million.  Althoughour business generated positive cash flow from operations over the six-monthperiod ending June 30, 2003, we have not yet achieved profitability and may notdo so during 2003. Even if we do achieve profitability, we may be unable tosustain or increase profitability on a quarterly or annual basis.

 

*Wehave a limited operating history with the Aspen suite, which makes it**difficult to predict our future performance.*

 

The primaryfocus of our business is and throughout 2003 will continue to be the Aspensuite.  We released the first version ofthe Aspen suite in September 2001 and released the first major upgrade inSeptember 2002. Accordingly, we have a limited operating history on whichto evaluate our current business and future prospects. Our limited operatinghistory with the Aspen suite makes it difficult to predict our futureperformance and may not provide investors with a meaningful basis forevaluating an investment in our common stock.

 

*Theenterprise learning software market is in the early stages of development**and may not grow to a sufficient size or at asufficient rate to sustain our**business.*

 

The enterprise learning software market is inthe early stages of development, and may not grow to a sufficient size or at asufficient rate for our business to succeed. Corporate training and educationhistorically have been conducted primarily through classroom instruction.Although technology-based training applications have been available for manyyears, they currently account for only a small portion of the overall corporatelearning market. Accordingly, our success will depend on the extent to which companiesimplement enterprise learning software solutions for the design, development,delivery and management of their corporate learning needs.

 

Many companies that have already investedsubstantial resources in traditional training methods may be reluctant to adopta new strategy that may limit or compete with their existing investments. Evenif companies implement enterprise learning software solutions, they may stillchoose to develop such solutions internally. If the use of enterprise learningsoftware does not become widespread or if companies choose to develop suchsoftware internally rather than acquiring it from third parties, then ourenterprise learning software may not be commercially successful.

 

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*Weface risks encountered in emerging markets and may be unsuccessful in**addressing these risks.*

 

We face risks frequently encountered in newand rapidly evolving markets. Specific risks we face relate to the demand forand market acceptance of our enterprise learning solutions. We may fail toadequately address these risks, and therefore our business may suffer. Toaddress these risks, we must:

 

•                       effectively market our enterprise learningsoftware to new and existing customers;

•                       continue to enhance the technology upon which ourenterprise learning software is based;

•                       successfully implement our enterprise learningsoftware for our customers and generate continuing revenue from thosecustomers; and

•                       address and establish new technologies andtechnology standards.

 

*Weface intense competition from other enterprise learning software providers**and may be unable to compete successfully.*

 

The enterprise learning software market ishighly fragmented and competitive, with no single firm accounting for a dominantmarket share. Our competitors vary in size, scope and the breadth of productsand services offered. We face competition from:

 

•                       other developers of enterprise learning systems;

•                       providers of other enterprise software solutions;

•                       large professional consulting firms and in-houseIT departments; and

•                       developers of web authoring tools.

 

There are relatively low barriers to entry inthe enterprise learning market and new competitors may enter this market in thefuture. Increased competition may result in price reductions, reduced grossmargins and loss of market share. We may not be able to contend effectivelywith such increased competition.  Inparticular, vendors of other enterprise software applications such as enterpriseresource planning, human resource management or customer relationshipmanagement have begun to offer learning delivery and management functionalityto extend their current product lines within their existing customer base.  Although these offerings may not offer thesame functionality as our Aspen suite, bundling these offerings with theremainder of their solutions could diminish our ability to sell our productsand services to their customers and announcements by these companies of futureproducts could delay purchasing decisions by their customers and our prospects,either of which could adversely affect our business.

 

Certain of our existing and potentialcompetitors have longer operating histories and significantly greaterfinancial, technical, marketing and other resources and therefore may be ableto respond more quickly to new or changing opportunities, technologies,standards and customer requirements or to compete more aggressively on pricing.Price competition would likely result in reduced gross margins and may preventthe Aspen suite from yielding results sufficient for our business to succeed.

 

Strategic relationships are important inexpanding the distribution reach of companies in the enterprise learningmarket. If our competitors were to establish strategic relationships to resellor distribute their products through their strategic partners, our ability tomarket and sell products and services successfully may be substantiallydiminished. In addition, the existence or announcement of strategicrelationships involving our competitors could adversely affect our ability toattract and retain customers.

 

*Internationaloperations may impose substantial burdens on our resources, divert**management’s attention or otherwise harm ourbusiness.*

 

We rely on independent partners in foreigncountries to help conduct our international operations and sales and marketingefforts. Our success in international markets consequently will depend to alarge

 

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degree onthe success of these independent partners, over which we have little control.If they are unwilling or unable to dedicate sufficient resources to ourrelationships, our international operations will suffer.

 

We rely on our operations in Hyderabad, Indiato enable us to complete customer implementation projects and new releases ofthe Aspen suite on time and within our established budgets.  Should our operations in Hyderabad bedisrupted for any significant period of time, it could prevent us fromcompleting customer implementations or new releases of the Aspen suite in atimely manner, which could cause our business to suffer.

 

Our efforts in Hyderabad and elsewhere abroadare subject to a number of risks inherent in international operations,including:

 

•                       diversion of management attention;

•                       difficulties and costs of staffing and managingforeign offices;

•                       different learning styles and cultures;

•                       numerous and potentially conflicting regulatoryrequirements;

•                       export controls, import tariffs and otherbarriers to trade;

•                       changes in laws or governmental policies;

•                       reduced protection of intellectual propertyrights;

•                       regional political and economic instability; and

•                       fluctuations in currency exchange rates.

 

*Ourdebt covenants may significantly restrict our operations.*

 

We are subject to numerous covenants in ouragreement with Silicon Valley Bank that impose financial and operatingrestrictions on our business if we wish to maintain availability of the creditfacility. These restrictions may affect our ability to operate our business,may limit our ability to take advantage of potential business opportunities asthey arise, and may adversely affect the conduct of our current business. Thesecovenants place restrictions on our ability to, among other things:

 

•                       incur debt with parties other than Silicon ValleyBank;

•                       pay dividends, redeem or repurchase our stock ormake other distributions;

•                       make acquisitions or investments;

•                       engage in new or different businesses;

•                       change our capital structure;

•                       use assets as security in other transactions;

•                       enter into transactions with affiliates oroutside the ordinary course of business;

•                       merge or consolidate with others or acquireassets outside the ordinary course of business;

•                       dispose of assets or use asset sale proceeds;

•                       create liens on our assets; and

•                       extend  orguaranty credit.

 

In addition, the terms of our indebtednessrequire that we meet certain financial covenants related to maximum net lossesand minimum tangible net worth. The covenants governing our existingindebtedness restrict our operations and those of our subsidiaries, and theselimitations could impair our ability to meet such financial covenants. Inaddition, our ability to meet these financial covenants and to comply withother provisions governing our indebtedness may be affected by changes ineconomic or business conditions or other events beyond our control. Moreover,failure to comply with our debt-related obligations could result in an event ofdefault that, if not cured or waived, could result in an acceleration of ourindebtedness.  We are currently incompliance with these covenants, but we cannot assure you that we will notviolate these covenants in the future. In the past, we have on occasion violated certain of the covenants underour loan agreements with Silicon Valley Bank and the bank has waived thoseviolations

 

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withoutcost to us.  However, we cannot assureyou that the bank will waive any future violations at no cost to us, or at all.

 

Moreover, because the amount available forborrowing under our agreement is based on our eligible accounts receivable, wemay from time to time become over-advanced under the line of credit if oureligible accounts receivable decrease, either because they have been collectedbut not applied against the existing obligations or because they have becomeineligible under the terms of the agreement. In such a case we may be required to immediately repay a portion of theamount borrowed sufficient to bring the total amount owed to no more than thetotal availability under the loan facility.

 

*Theloss of the services of our senior executives and key personnel would**likely cause our business to suffer.*

 

Our success depends to a significant degreeon the performance of the senior management team and other key employees. Theloss of any of these individuals could harm our business. We do not haveemployment agreements with several of our executives or with any other keyemployees, and we do not maintain key person life insurance for any officers orkey employees.

 

Our success also depends on our ability toattract, integrate, motivate and retain highly skilled technical, sales andmarketing and professional services personnel. Competition for qualifiedpersonnel in the enterprise software industry is intense. To the extent we areunable to attract and retain skilled personnel our business will suffer.

 

*OurAspen suite is a new product and may contain defects or otherwise**perform improperly.*

 

Our Aspen suite was initially released in September 2001,and the first major version upgrade was released in September 2002.  We anticipate continuing to add newfeatures, functionality and components. Complex enterprise software productsfrequently contain errors or failures, especially when first introduced or whennew versions are released. Because the Aspen products are complex softwarepackages with new features and functionality being added and new versions beingreleased on a regular basis, there is a greater likelihood that they may containsuch errors. In addition, since the Aspen suite is targeted at enterprisecustomers with large numbers of users, customers and potential customers mayhave a greater sensitivity to product defects or product integration than themarket for software products generally. To date we have experienced errors inthe Aspen platform, in particular when new versions or functionality is firstreleased, although such errors have not had a material impact on our businessand generally have been corrected shortly after discovery.  Although we have not experienced this todate, serious product errors could result in loss of revenue or delay in marketacceptance, diversion of development resources, damage to our reputation, orincreased service and warranty costs.

 

*Wemay not be able to adapt to rapidly changing technology and evolving**industry standards.*

 

The enterprise learning software market ischaracterized by rapidly changing technologies, frequent new product andservice introductions, short development cycles and evolving industrystandards. The introduction of new products and services embodying newtechnologies and the emergence of new industry standards may render ourproducts and services obsolete. Our success depends on our ability to adapt toa rapidly changing landscape and to offer new products and services to addressour customers’ changing demands. We may experience difficulties that delay orprevent the successful design, development, introduction or marketing of ourproducts and services. To the extent we in fact experience such delays, we mayexperience difficulty in attracting new customers and may lose existingcustomers.

 

*Ifwe are unable to build the Click2learn and Aspen brands, we may be unable to**grow our business.*

 

We believe that establishing and maintainingthe Click2learn and Aspen brands will be critical to the success of ourenterprise learning strategy and that the importance of brand recognition willincrease as

 

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themarket for enterprise learning software products grows. If our brand buildingstrategy is unsuccessful, our business could be materially harmed.

 

*Weface the risk of liability for failures to meet unique customer**requirements, and the risk of cost overruns onfixed-price projects.*

 

The failure or inability to meet a customer’sunique expectations or requirements in the performance of services could impairour reputation or result in a claim for damages, regardless of ourresponsibility for the failure. Although generally we attempt to limitcontractually our liability for damages arising from product defects and othermistakes in rendering professional services, these contractual protections arenot always obtained and may not be enforced or otherwise may not protect usfrom liability. Our insurance may not be sufficient to cover these claims.  In addition, most of our professionalservices projects are performed on a fixed-price basis rather than on a timeand materials basis. If we do not complete fixed-price engagements within budget,on time and to clients’ satisfaction, we bear the risk of cost overruns.

 

*Securityand privacy breaches could subject us to litigation and liability.*

 

We host certain of our customers’ enterpriselearning software implementations at our data center and provide access to thatsoftware using the Internet. The Internet is a public network and data is sentover this network from many sources. Although we take reasonable steps inaccordance with current industry practices to ensure the security of our hostingsystems and customer data, computer viruses could be introduced into oursystems or those of our customers, which could disrupt the operation of ourhosting systems or make them inaccessible to users. We depend on Internetservice providers and telecommunications companies and the efficient operationof their computer networks and other computer equipment to enable customers toaccess and use hosted software implementations. Each of these has experiencedsignificant outages in the past and could experience outages, delays and otherdifficulties due to system failures unrelated to our systems, which could causeour customers to believe we were at fault and withhold payments due to us.

 

We could become subject to litigation andliability if third parties penetrate security for our hosting systems orotherwise misappropriate our users’ confidential information or if customersare unable to access and use hosted software implementations. Advances incomputer capabilities, new discoveries in the field of cryptography or othertechnological events or developments could result in compromises or breaches ofour security systems. Anyone who circumvents our security measures couldmisappropriate proprietary information or cause interruptions in our servicesor operations. We may be required to expend significant capital and otherresources to protect against the threat of security breaches or serviceinterruptions or to alleviate problems caused by breaches or serviceinterruptions.

 

*Acquisitionsor investments may drain capital and equity resources, divert**management’s attention or otherwise harm ourbusiness.*

 

In the future we may acquire or makeinvestments in other businesses, products or technologies. Such acquisitions orinvestments may require that we pay significant cash, issue stock or incursubstantial debt. In addition, such acquisitions or investments may requiresignificant managerial attention, which may be diverted from our otheroperations. These capital, equity and managerial commitments may impair theoperation of our business. Furthermore, acquired businesses may not beeffectively integrated, may be unable to maintain key pre-acquisition businessrelationships, may contribute to increased fixed costs and may expose us tounanticipated liabilities.

 

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*Ourintellectual property may become subject to legal challenges, unauthorized**use or infringement, any of which could diminish thevalue of our products and**services.*

 

Our success depends in large part on ourproprietary technology. We rely on a combination of copyrights, trademarks,trade secret laws, restrictions on disclosure and other methods to protect ourproprietary technology.  We do not havepatents for any of the technology underlying our Aspen platform. If we fail tosuccessfully enforce our intellectual property rights, the value of theserights, and consequently the value of our products and services to ourcustomers, could diminish substantially. It may be possible for third partiesto copy or otherwise obtain and use our intellectual property or trade secretswithout our authorization, and it may be possible for third parties toindependently develop substantially equivalent intellectual property.

 

Litigation may be necessary in the future toenforce our intellectual property rights, to protect trade secrets or todetermine the validity and scope of the proprietary rights of others. From timeto time we have received, and may in the future receive, notice of claims ofinfringement of other parties’ proprietary rights. Such claims could result incostly litigation and could divert management and technical resources. Theycould also delay product shipment or require us to develop non-infringingtechnology or enter into royalty or licensing agreements, which agreements maynot be available on reasonable terms, or at all.

 

*Ourproducts include third-party technology, the loss of which could materially**harm our business.*

 

We use some licensed third-party technologycomponents in our products. Future licenses to this technology may not beavailable to us on commercially reasonable terms, or at all. The loss of orinability to obtain or maintain any of these technology licenses could resultin delays in the introduction of new products or could force us to discontinueoffering portions of our enterprise learning solutions until equivalenttechnology, if available, is identified, licensed and integrated. Furthermore,we may become subject to legal claims related to licensed technology based onproduct liability, infringement of intellectual property or other legaltheories.

 

*Our stock price has beenand may continue to be volatile.*

* *

The trading price of our common stock has been and is likely tocontinue to be highly volatile.  Forexample, during the 52-week period ended June 30, 2003, the price of ourcommon stock ranged from $0.23 to $4.90 per share.  Our stock price is subject to continued fluctuations in responseto a number of factors, including:

 

•                       actualor anticipated variations in quarterly operating results;

•                       changesin financial estimates or recommendations by securities analysts;

•                       conditionsor trends in the learning and enterprise software markets;

•                       announcementsby us or our competitors of significant customer wins, technological innovations,new products or services;

•                       announcementsby us or our competitors of significant acquisitions, strategic partnerships,joint ventures or capital commitments;

•                       additionsor departures of key personnel;

•                       salesof our common stock; and

•                       generalmarket conditions.

 

The stock market in general, and the market for enterprise software andtechnology companies in particular, recently has experienced extreme price andvolume fluctuations that have been unrelated or disproportionate to theoperating performance of many of the affected companies.  These broad market and industry factors maydepress our stock price, regardless of our operating performance.

 

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In the past, companies that have experienced volatility in the marketprice of their stock have been subject to securities class actionlitigation.  We may be the targets ofthis type of litigation in the future. Securities litigation against us could result in substantial costs anddivert our management’s attention, which could seriously harm our business.

 

**Item 3.****Quantitative and Qualitative Disclosures about Market Risk**

 

*Market Rate Risk.*We are exposed to market risk related to changesin interest rates and foreign currency exchange rates. We do not use derivativefinancial instruments for speculative or trading purposes.

 

*Interest Rate Risk.*We hold our assets primarily in cash and cashequivalents, such as short-term marketable debt securities, money market fundsand other cash equivalents. We minimize risk by investing in financialinstruments with maturity of three months or less. As a result, if marketinterest rates were to increase immediately and uniformly by 10% from levels atDecember 31, 2002, the fair value of cash and cash equivalents would notchange by a material amount.

 

*Foreign Currency Exchange Risk.*We have foreign currency risk as a result offoreign subsidiary activities. For the three and six months ended June 30,2003, international revenue from foreign subsidiaries accounted for approximately9%  and 8%, respectively, of totalrevenue. All foreign subsidiaries use the local currency as their functionalcurrency.

 

Our exposure to foreign exchange ratefluctuations arises in part from intercompany accounts in which costs incurredin the United States are charged to the foreign subsidiaries. Theseintercompany accounts are typically denominated in the functional currency ofthe foreign subsidiary in order to centralize foreign exchange risk with theparent company in the United States. We are also exposed to foreign exchangerate fluctuations as the financial results of foreign subsidiaries aretranslated in U.S. dollars in consolidation. As exchange rates vary, theseresults, when translated, may vary from expectations and adversely impactoverall expected profitability. The effect of foreign exchange ratefluctuations for the six months ended June 30, 2003 was not material. Dueto the substantial volatility of currency exchange rates, among other factors,we cannot predict the effect of exchange rate fluctuations on our futureoperating results.

 

**Item 4.**  Controls and Procedures

** **

Click2learn maintains a set of disclosurecontrols and procedures designed to ensure that information required to bedisclosed in filings made pursuant to the Securities Exchange Act of 1934 (the“Exchange Act”) is recorded, processed, summarized and reported within the timeperiods specified in the Securities and Exchange Commission’s rules and forms.Our principal executive and financial officers have evaluated our disclosurecontrols and procedures as of the end of the period covered by this report andhave determined that such disclosure controls and procedures are effective.

 

No changes were made to our internal control over financial reportingin connection with this evaluation that has materially affected, or isreasonably like to materially affect, our internal control over financialreporting.

 

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### **PART II**—OTHER INFORMATION

 

**Item1.  LegalProceedings**

 

Not applicable.

 

**Item2.  ChangesIn Securities and Use of Proceeds**

 

On June 20, 2003, we sold to certainaccredited investors a total of 7,460,644 shares of our common stock at a priceof $1.668 per share in a private placement transaction. We also sold warrantsto purchase 2,611,225 shares of common stock at an exercise price of $1.90 pershare.  The purchase price for thewarrants was $0.125 per warrant share. Craig-Hallum Capital Group LLC acted as placement agent in thetransaction.  The aggregate offering pricefor the shares and warrants was approximately $12,771,000 and the placementagent received a fee of $703,392 for its services along with warrants for thepurchase of an additional 373,032 shares on the same terms as the warrantsissued to investors.

 

The sale of shares andwarrants was made only to accredited investors pursuant to Rule 506 ofRegulation D under the Securities Act of 1933 as amended (“the Act”) and wastherefore exempt under the Act.  Aregistration statement on Form S-3 was filed subsequent to the end of thefiscal quarter with respect to the resale of the shares sold in the privateplacement and issuable upon exercise of warrants.

 

The warrants have a term of five years.  They become exercisable on December 21, 2003 and remainexercisable at any time prior to their expiration in whole or in part upon thepayment of the exercise price for the number of shares with respect to whichthe warrants are being exercised.  Inaddition, the warrants may be exercised on a net exercise basis, pursuant towhich the exercise price for an exercise of warrants is paid by thecancellation of a portion of the shares being exercised having a fair marketvalue equal to the exercise price for all the shares being exercised.  However, a net exercise may only be made ifthere is not an effective registration statement in place on the date of suchexercise covering the resale of the warrant shares and the warrant sharescannot be resold pursuant to Rule 144(k).

 

**Item3.  Defaults UponSenior Securities**

 

Not applicable.

 

**Item4.  Submissionof Matters to a Vote of Securities Holders**

 

The 2003 Annual Meeting of the Stockholders of Click2learn was held onMay 28, 2003 at 110  110thAvenue NE, Bellevue, Washington.  Themeeting was held pursuant to a Notice of Annual Meeting of Stockholders mailedto the stockholders on or about April 23, 2003.  Two proposals were submitted to the stockholders and approved atthe annual meeting, as follows:

 

*Proposal 1:*Election of Kevin M. Oakes, RonaldS. Posner and Jonathan Morgan asClass II directors to serve until the annual meeting of the stockholders to beheld in 2006.  The number of votes castfor or withheld from each nominee, both in person and by proxy, was as follows:

 
|            |   | **Kevin M. Oakes** |   | **Ronald S. Posner** |   | **Jonathan Morgan** |   |
|-----------------|--------|--------------------|--------|----------------------|--------|---------------------|--------|
| Votes For       |   | 21,351,985         |   | 18,294,674           |   | 21,625,035          |   |
| Votes  Withheld |   | 309,455            |   | 3,366,766            |   | 36,405              |   |

 

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*Proposal 2:*Ratification of the appointment ofKPMG LLP as our independent accountants to perform the audit of our financialstatements for 2003. The number of votes cast for, cast against or abstainingfrom Proposal 2, both in person and by proxy, was as follows:

 

| Votes For      |   | 21,648,758 |   |
|----------------|--------|------------|--------|
| Votes  Against |   | 5,105      |   |
| Abstaining     |   | 7,577      |   |

 

**Item 5. Other Information**

 

*Changes to Audit Committee. *On July 2, 2003,Ronald S. Posner resigned as a member and as Chairman of the AuditCommittee.  Mr. Posner resigned from the Audit Committee because hiscurrent schedule did not permit him to devote the time he felt was appropriateto devote as a member of the Audit Committee. There has been no disagreement between Click2learn and Mr. Posner on anymatter relating to Click2learn’s policies or practices.  As a result of Mr. Posner’s resignation, theBoard reduced the size of the Audit Committee from four directors to three andappointed Jonathan Morgan as Chairman. Mr. Posner will continue to serve as a member of the Board.

 

**Item6.  Exhibitsand Reports on Form 8-K**

 
| (a)    |   | Exhibits.                                                                                                                                                                       |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                            |
| 10.01* |   | Employment Agreement dated as of  June 26, 2003 between Click2learn and Sudheer Koneru.                                                                                    |
|   |   |                                                                                                                                                                            |
| 10.02* |   | Employment Agreement dated as of  June 26, 2003 between Click2learn and Srinivasan Chandrasekar.                                                                           |
|   |   |                                                                                                                                                                            |
| 31.1   |   | Certifications of Chief Executive Officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                            |
|   |   |                                                                                                                                                                            |
| 31.2   |   | Certification of Chief Financial Officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                             |
|   |   |                                                                                                                                                                            |
| 32.1   |   | Certification of Chief Executive Officer  and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |

 

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*Managementcontract or compensatory plan or arrangement.

 

(b)          Reports on Form 8-K.

 

A report on Form8-K dated June 20, 2003 was filed announcing the privateplacement to accredited investors of 7,460,000 shares of our common stock andwarrants to purchase an additional 2,611,225 shares of our common stock. No financial statements were filed with suchreport.

 

A report on Form8-K dated June 2, 2003 was filed announcing changes to the executivemanagement team. No financial statements were filed with such report.

 

A report on Form8-K dated April 24, 2003 was filed announcing results of operations forthe three months ended March 31, 2003. No financial statements were filed with such report.

 

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**SIGNATURES**

 

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

 
|                 | **CLICK2LEARN, INC.**                                    |
|----------------------|----------------------------------------------------------|
|                 |                                                     |
|                 |                                                     |
| August 11, 2003 |                                                     | /s/John D. Atherly |
| Date                 |                                                     | John D. Atherly |
|                 | Vice President, Finance and Administration               |
|                 | and Chief Financial Officer                              |
|                 | (Duly Authorized Officer and Chief  Accounting  Officer) |

 

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**Exhibit List**

 
| 10.01* |   | Employment Agreement dated as of  June 26, 2003 between Click2learn and Sudheer Koneru.                                                                                    |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                            |
| 10.02* |   | Employment Agreement dated as of  June 26, 2003 between Click2learn and Srinivasan Chandrasekar.                                                                           |
|   |   |                                                                                                                                                                            |
| 31.1   |   | Certifications of Chief Executive Officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                            |
|   |   |                                                                                                                                                                            |
| 31.2   |   | Certifications of Chief Financial Officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                            |
|   |   |                                                                                                                                                                            |
| 32.1   |   | Certification of Chief Executive Officer  and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |

 

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*Managementcontract or compensatory plan or arrangement.

 

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