** **

**UNITED STATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10-K**

** **

| **(Mark One)**                                                                                                                                                                                     |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **ý****   ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE****SECURITIES EXCHANGE ACT OF 1934**                                                                                |
|                                                                                                                                                                                               |   |   |
| **For the  fiscal year ended December 31, 2002**                                                                                                                                                   |
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| **OR**                                                                                                                                                                                             |
|                                                                                                                                                                                               |
| **o****   TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                    |
|                                                                                                                                                                                               |   |   |
| **For the  transition period  from             to             ** |

 

**Commission filenumber 0-21421**

 

**VCAMPUSCORPORATION**

(Exact name of registrant as specified in itscharter)

** **

| **Delaware**                                                    |   | **54-1290319**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
|                                                            |   |                                  |
| **1850  Centennial Park Drive**                                 |   |                                  |
| **Suite 200**                                                   |   |                                  |
| **Reston,  Virginia**                                           |   | **20191**                             |
| (Address of principal executive offices)                        |   | (Zip Code)                            |

 

Registrant’s telephone number, including areacode: **703-893-7800**

 

Securities registered pursuant to Section 12(b)of the Act:

**None**

 

Securities registered pursuant to Section 12(g)of the Act:

 

**Common Stock($0.01 par value per share)**

 

Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days.  Yes  ý   No  o

 

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this Form10-K.  o

 

Indicate by check mark whetherthe registrant is an accelerated filer (as defined in Rule 126-2 of the Act)Yes  o  No  ý

 

The aggregate market value of the common stock held bynon-affiliates of the registrant based upon the closing price of the CommonStock on June 30, 2002, on the Nasdaq SmallCap Market System was approximately$4,468,611 as of such date. Shares of Common Stock held by each executiveofficer and director and by each person who owns 10% or more of the outstandingCommon Stock have been excluded in that such persons may be deemed to beaffiliates. This determination of affiliate status may not be conclusive forother purposes.

 

As of March 26, 2003, theregistrant had outstanding 1,581,307 shares of Common Stock.

 

**DOCUMENTSINCORPORATED BY REFERENCE**

 

Portions of the Company’s Proxy Statement for the 2003Annual Meeting of Stockholders are incorporated herein by reference into PartIII.

 

 

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NOTE REGARDING FORWARD-LOOKINGSTATEMENTS

 

*Statements in this Annual Report on Form 10-K that arenot descriptions of historical facts are forward-looking statements that aresubject to risks and uncertainties. Actual events or results could differmaterially from those currently anticipated due to a number of factors,including those set forth herein and in the Company’s other SEC filings, andincluding, in particular: limited operating history in targeted markets; lossesand negative operating cash flows; future capital needs and uncertainty ofadditional funding; difficulties in managing rapid growth; risks associatedwith acquisitions and integration of acquired operations; competition;developing market, rapid technological changes and new products; dependence ononline distribution; substantial dependence on courseware and third partycourseware providers; substantial dependence on third party technology; andlimited marketing experience and substantial dependence on third partydistribution. All references to the “Company” or “VCampus” herein shall meanVCampus Corporation and its subsidiaries: Cognitive Training Associates, Inc.,a Texas corporation (“CTA”); Cooper & Associates, Inc., an Illinois corporation,d/b/a Teletutor (“Teletutor”); HTR, Inc., a Delaware corporation (“HTR”); andUOL Leasing, Inc., a Delaware corporation.*

 

##### **PARTI**

 

**Item 1.  Business.**

 

VCampus Corporation (orthe “Company”)  is a leading provider ofoutsourced e-learning solutions. The Company manages and hosts Internet-basedlearning environments for corporations, government agencies, institutions ofhigher education, and associations. The Company’s services cover a broad rangeof e-learning programs, from enrollment and payment to course development anddelivery, as well as tracking of students’ progress and reporting of results.

 

Through its proprietarysoftware the Company provides customers with comprehensive solutions on anoutsourced, or hosted, basis.  TheCompany believes that its outsourced hosting approach to web-based e-learningservices provides significant business advantages to its customers. The Companycharges customers a relatively low upfront fee to establish a customizedvirtual campus, or “vcampus”, and then charges customers on either asubscription or usage basis for the service on an ongoing basis.  The Company believes this model creates aconsistent revenue stream, as well as a “backlog” of revenue for the Company.  The Company believes that these factors, particularlywhen combined with the relatively high switching costs customers incur tochange e-Learning service providers, provide a solid revenue base for theCompany.  The Company believes itsmarket strengths to be:

 

•                  arapid, non-time-consuming implementation, achieved in a matter of days;

•                  minimalupfront investment required for the service;

•                  ready-to-golibrary of over 7,200 online courses;

•                  consistentdelivery of high-quality courseware;

•                  provensystem performance and scalability;

•                  deliveryof content from virtually any source; and

•                  systemcompliance with industry standards (SCORM (Shareable Content Object ReferenceModel), Section 508 (of the Federal Rehabilitation Act), AICC (AviationIndustry Computer-based Training Committee – established standards ofinteroperability) and SOAP (Simple Object Access Protocol).

 

VCampus believes that itholds several key advantages in the e-learning marketplace:

 

**Diversecustomer list**. VCampus has a diverse set ofcustomers, including relationships with the Company that have extended for asmany as six years. VCampus’ customer base is noteworthy for representing a widerange of sectors, including corporations, government agencies, institutes ofhigher education, professional associations and retail-oriented training sites.

 

**Diversifiedbusiness base**. VCampus serves customers from a widevariety of market sectors – including corporations, associations, governmentagencies, and institutes of higher education. As such, the Company is able toprovide its customers with a unique ability to participate in communities oflearning. The VCampus platform enables VCampus customers to share content,thereby creating

 

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cross-sale opportunitiesfrom customer to customer. Several VCampus customers successfully sell theircontent to other VCampus customers simply by offering their content on theadvanced Vcampus platform.

 

**Opentechnology.** The VCampus technology affords customers anumber of advantages in terms of its ability to rapidly and cost-effectivelyimplement a comprehensive and secure e-learning and training environment.  The Company’s content-neutral, openarchitecture platform allows for access to a wide range of aggregated content,the ability to quickly add new functionality, leverage new technology and tosupport a vast number of users. The Company’s recently introduced web servicescapabilities enable customers to easily integrate VCampus technology with otherexisting systems (including enterprise resource planning systems and humanresource information systems).

 

**Expansivelibrary of content aggregated from leading sources.** UsingVCampus’s proprietary course development technology, known as its CourseConstruction Set, a customer’s own training materials may be combined with theCompany’s off-the-shelf, third-party content library consisting of thousands ofcourses, on subjects including management skills, information technology,telecommunications and personal development, to design a comprehensive trainingcurriculum.  The Company’s existingcontent library, marketed as ContentMattersä,includes over 2,500 publicly-available online courses from approximately 25leading providers, including SkillSoft, NETg, Element K, American Media,Dearborn Financial Publishing, NIIT and Crisp Learning. The Company also hasagreements to distribute some courseware that has been developed by itscustomers, such as the New York Institute of Finance, to other VCampuscustomers. VCampus’ wholly-owned library of telecommunications and desktoppublishing courses are marketed under the Teletutor and VCampus brand names.

 

**Extensiveexperience**. The Company has delivered over 2.6 millioncourses over the past seven years. Currently the Company has over 740,000 enrolled users.  The Company has operated in the e-learningspace for more than seven years. VCampus maintains solid, long-termrelationships with established customers and benefits from a highly experiencedand knowledgeable management team.

 

**Flexibility***.*The Company’s technology and implementation process is flexible to respond todiverse customer needs. The Company offers rapid implementation on acontent-neutral platform that allows access to both off-the-shelf andproprietary courseware. The Company offers customization of its products andservices for each customer, as well as rapid incorporation of new technologies.The Company’s technology and services are designed to be scaleable on demand tomeet customer needs.

 

**Comprehensive Solution*.***VCampus offers a completely hosted solution, accessible by virtually any webbrowser. The VCampus solution includes a leading edge Learning ManagementSystem, Course Construction Set TM and Courseware Delivery Engine. Thetechnology and service have been proven and tested through successful implementationsfor scores of customers, where thousands of students have experiencedVCampus-based e-Learning for up to seven years.

 

**Industry Background**

 

The Company believes themarket for e-learning, with a 2002 market size of approximately $10.3 billion inthe U.S. according to Brandon-Hall, is continuing to grow, in spite of the “dotcom” crash and the current downturn in the economy.  Both IDC and Brandon-Hall expect an increase in corporate andgovernment e-learning spending in 2003 and beyond, with IDC predicting acompound average growth rate (CAGR) of 36.7 percent between 2001 and 2006.  Management believes this steady increaseprovides the Company with significant opportunity for growth.  Additionally, the Company expectssignificant industry growth in content revenues.

 

IDC updated itsprojections for the corporate e-learning market worldwide in January 2003 inits study entitled “Market Analysis: Begin Act II:  Worldwide and U.SCorporate e-learning Forecast 2002-2006.” This study predicts the market will grow from $6.6 billion in 2002 to$23.7 billion in 2006.  The US marketrepresents the largest national e-learning market for vendors and IDC predictsit will grow 36.5% over the next five years. IDC reports that corporate e-learning remains one of the fastest growingmarkets it tracks and presents vendors with the opportunity for financialsuccess.

 

Overall findings bymultiple organizations show an increase in the e-learning market in 2002, withan increase again in 2003 and beyond.  Astudy by Brandon-Hall, entitled “The Growth of e-learning in 2002:  Profile of Industries and Departments,”found that of the 112 responses from corporate users, 89 percent said at leastone department within their organization had started using or expanded its useof e-learning since the beginning of the year. Additionally, 94 percent of the respondents said they plan to expand theuse of e-learning in at least one area of their company in 2003.

 

In spite of the economicdownturn and the slow recovery of corporate training budgets, e-learningcontinues to gain share against its mainstay education and trainingcounterparts.  Buyers in 2001 and 2002became more educated about e-learning as a solution and a process.  Purchasers in this dynamic market are moreeducated than the earliest adopters of e-learning.  The Company believes corporate buyers will drive longer salescycles, rigorous sets of requirements in requests for proposals (RFPs), andwill be

 

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focused on addressingbusiness needs.  Additionally, theCompany has observed that sales cycles have lengthened in both the governmentand commercial markets, averaging between 8 and 12 months.

 

**Company Strategy**

 

The Company’s mission isto be the leading service provider of integrated e-learning solutions byhelping customers improve their performance and achieve their goals. TheCompany’s strategies to achieve this objective include continuing to: focus onhigh-revenue opportunities, develop strategic relationships, develop strategiccontent, provide superior customer service, and develop new and upgradeexisting technologies. The Company’s strategy also includes increasing revenuefrom each customer by converting more of each customer’s proprietary content toonline distribution through the VCampus platform.  The Company also intends to grow the cross-selling of contentbetween various customers. The intended result is increased penetration andenhanced customer loyalty.

 

*Focus on High-Revenue Opportunities*

 

VCampus is focused onfinding and developing new opportunities for significant revenue based on threefactors. The Company seeks sales opportunities in which: 1. training is for a *largeaudience* (e.g., employeebase of government institution or corporation or students of distance educationschool); 2. training is *required* (e.g., mandatory for employees, required certification, academicdegree); and 3. training is *paid for by a third party*, not by thestudent (e.g., paid directly by employer or through tuition assistanceprograms).

 

The Company believes thatthe highest-growth segment of the e-learning market is the service of onlinedistance education programs for institutions of higher education. Although theCompany maintains customers in this segment, management believes the Company’stechnology needs to become more competitive for this segment. Consequently, theCompany is currently developing upgraded technology designed to attract andmaintain higher education customers. Additionally, the Company is working todevelop significant new customer relationships with institutions of highereducation offering significant distance learning programs online.

 

*Develop Strategic Relationships*

 

Based on successwith  past and current relationshipswith several customers, the Company targets organizations that provide theopportunity for mutual benefit from a multi-faceted relationship. Typically,target partners provide classroom-based training to a wide audience but havenot yet incorporated online training into their training model. VCampus enablesorganizations to add online learning quickly, efficiently and inexpensively.Collaboration opportunities include online delivery of content the customerconverts, conversion and online delivery of courses by the Company and developmentof courses for online delivery which would be owned, at least partially, by theCompany.

 

*DevelopStrategic Content*

 

The Company invests inthe development of courses deemed strategic in nature to attract customers withstrong revenue prospects. Typically, these courses are developed incollaboration with a recognized subject matter expert. Content considered forco-development must lend itself a large, reachable audience and offer theaudience a powerful reason to attend the course (e.g., compliance with laws,certification, Continuing Professional Education credits (CPEs) or ContinuingEducation Units (CEUs)). Examples of strategically-developed courses at VCampusinclude Information Security and several HIPPA (Health Insurance Portabilityand Accountability Act) courses. Courses so developed may be owned, at leastpartially, by the Company.

 

*Provide Superior Customer Service*

 

VCampus’ core customerservice principle is to deliver uniquely superior service through creative,committed and well-trained employees who work as a team.  The Company utilizes TeamCareSM,a service methodology grounded upon developing relationships between keyplayers from both VCampus and each customer. The partnership includes an executive member, a project manager, an accountmanager and the customer care center. Each member of the team has a definedseries of roles and responsibilities for monitoring and supporting the healthand growth of the customer relationship. Furthermore, the team is responsiblefor continuous review of the customer’s content needs, introduction of existingand new VCampus services, recommendation of suitable additional content,identification of the potential need for custom courseware development,pedagogy and instructional design and the recommendation of platformconfigurations for customer-specific business processes.

 

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*Developand Upgrade Proprietary Technology*

 

The Company intends tomaintain its position as a leader in online courseware delivery technology bycontinuing to develop and enhance the features and functionality of itsproprietary technology. VCampus’s system is designed to accommodate users onboth low and high bandwidth connections, enabling the Company to serve a widerange of end users without requiring a large investment on their part.Additionally, the VCampus system is a completely outsourced system; noinvestment in software or hardware is required of customers or students (otherthan access to the Internet via a web browser).

 

During 2002, VCampusannounced the Launch of VNexusTM, a next generation platform making VCampus thefirst e-learning company to launch a fully SOAP-compliant Learning Managementplatform with superior web services capabilities. By standardizing on the SOAPprotocol, VNexus employs XML, a recognized universal standard, to communicatewith an organization’s information technology infrastructure. XML providesinherent flexibility because it can operate across any operating system orplatform, thereby reducing possible barriers to integration. Recognizing thatsome organizations have not standardized on XML, VCampus also offers othercommunication formats with VNexus.

 

VCampus plans to releasemajor upgrades of its technology during 2003 as well. The Company believesthese upgrades will lower the cost of course delivery, increase the scalabilityand reliability of the system and improve the ease of use for both learners andcontent courseware authors. The Company plans major platform upgrades designedto dramatically increase the technology’s applicability to the higher educationdistance learning market.

 

**Products and Services**

 

VCampus offers a widerange of products and services, the majority of which center around a virtualcampus or “vcampus.” The vcampus mimics the functions of a university campus onthe Internet – handling student admissions, registrations, course delivery,grading and tracking. Customers are able to choose from the Company’s extensiveoff-the-shelf library, convert existing courses to an online format, or usecourses provided by another vendor, all for use within their vcampus.

 

The Company’s technologyallows customers to use a variety of content on an open, internet-basedarchitecture, on an outsourced hosting basis. The system displays eachcustomer’s graphical “look and feel.”  Management believes this open architecture makes VCampus’ hostedtechnology more flexible than that of many of its competitors.

 

The Company’s vcampus isa centrally-hosted e-Learning delivery and tracking system accessible byvirtually any Internet-ready PC. Students generally enroll in the Company’scourses online through a VCampus, but have the option to enroll in person, bytelephone or through the mail. Customers also have the ability to registerstudents in bulk. Once registered, students can access the courseware online, typically through a PCconnected to the Internet or through a corporate intranet or extranet. When astudent has completed the course, he or she will receive credit orcertification, if appropriate. The VCampus technology is a proven system,having served approximately 2.6 million courses since introduction.

 

The VCampus environmentis customizable and designed for ease of administration and access to students,instructors and training administrators. In addition, by using any combinationof courses from the Company’s courseware library and the customer’s owninternal training libraries, customers can offer a variety of distance learningoptions.

 

The VCampus supports awide variety of tools and utilities supplied by third parties, such as NetscapeNavigator/Communicator, Microsoft Internet Explorer, Macromedia Shockwave andFlash, Real Networks Streaming, and other browser-based plug-ins.  In addition, the Company has developed thefollowing proprietary software tools that facilitate the functionality of theVCampus:

 

*The Courseware Delivery Engine*— a proven system for presenting the total e-learning experience. This productwas designed and built to serve as an integrated, Web-based coursewareconstruction and delivery tool. First delivered in August 1997, the product hasbeen used to build and deliver the Company’s courseware library of more than7,200 online courses as of December 31, 2002. The VCampus Courseware DeliveryEngine provides a simple, easy-to-use environment for instructors and studentscapable of assessing, tracking and testing students as they complete a course.

 

*The Course Construction Set*— is designed to be simple to use yet rich in possibilities and performance.The courseware developer has access to a complete suite of Web-based toolsnecessary to construct and deliver highly interactive, online courses. The“PointPage” functionality of the product provides a choice of methods fordisplaying content. The “Activity Studio” enables non-programmers to constructand include multimedia-rich (animation, sound and student interactivity)activities by answering a few simple questions. Courseware developers can alsotake advantage of the testing system, which includes many advanced featuressuch as question randomization and pooling. Additionally, courseware developerscan

 

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choose to link selectedtest questions and PointPages to learning objectives, which allows a coursewaredeveloper to group content and assess a student’s progress based onperformance.

 

*The Curriculum Group Manager*— allows training managers to create an enterprise-wide individualized trainingprogram by facilitating the grouping of students with similar education needsand abilities to appropriate groups of courses within a VCampus. The result isa specific student “Training Plan” designed to guide students to courses thatmatch the student’s ability. Additionally, the Training Plan can evaluate astudent’s performance in each course against standards established for testscores and attendance.

 

*Batch/Mass Enrollment Tools*— facilitate the enrollment of large groups into the vcampus and/or courses.Organizations with a large population of students can use this tool to importdemographic data from legacy enterprise resource planning or human resources systems,thus streamlining the implementation process.

 

To provide a completelearning experience for customers, the Company also provides threadeddiscussions (*VDiscussion*), live virtual meetings (*VMeeting*), online surveys (*VSurvey*),platform administrator training, Course Construction Set training, e-Learningconsulting on strategy and overall programs, custom courseware development andintegration with other systems through VNexus.

 

**ExistingCourseware Library**

 

The Company currentlyoffers approximately 7,200 courses real-time on its e-learning system and hasthe rights to offer an additional 2,600 which can be promptly added in responseto customer requests.  The Company’s2,500 publicly-available courses are marketed under the name****ContentMattersTM.The Company’s courseware strategy involves the provision of the following threecomponents:  (1) strategically-developedcourses from VCampus; (2) COTS, or commercial off-the-shelf, courses from avariety of leading third-party course vendors; and (3) custom coursewaredevelopment for the proprietary training needs of the Company’s customers.

 

*Strategically Developed Courses*

 

The Company invests inthe development of courses which management deems strategic in nature toattract customers with strong revenue prospects. Typically, this type of courseis developed in partnership with a leading expert in the field. Contentconsidered for co-development must target a large, reachable audience and offerthe audience some compelling reason to attend the course (e.g., compliance withlaws, certification, CPEs or CEUs). Examples of strategically-developed coursesinclude Information Security and several HIPPA courses. Courses so developedmay be owned, at least partially, by the Company.

 

*COTSLibrary*

 

The Company currentlyoffers approximately 2,500 online courses real-time on its e-learning systemand has the rights to offer an additional 2,600 which can be promptly added inresponse to customer requests.  Thecurrent library was built from a combination of acquisitions, the Company’s owndevelopment efforts and relationships with leading content providers such asSmartForce, NETg, NIIT, Infosource, Vital Learning, Crisp Publications Inc.,Marcom, Aztec Software and American Media Inc. Although the Company does not provide accreditation or certificationitself, a number of its current courses provide either accreditation orcertification through its content providers.

 

*CustomLibrary*

 

The Company’s existingcustom courseware library includes approximately 4,700 online courses built byVCampus corporate, higher education and government customers for their ownproprietary use.  The Company believesthese courses provide more long-term revenue potential than commercialoff-the-shelf courses, which are beginning to become commoditized and mightcontinue to become so over time.  TheCompany believes the growth of this custom library is evidence of customersatisfaction with the Company’s authoring and delivery products.

 

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**Customers**

 

The Company’s primarytarget markets are the government, corporate training and higher educationdistance learning markets. As a result of the telecommunications market“melt-down,” the Company experienced high customer turnover due to its heavyexposure to telecommunications customers. Since 2001, Management hasintentionally broadened the customer base of the Company to reduce thevulnerability to a downturn in any one particular market. The Company’s onlinetuition revenues were balanced fairly equally among the three segments in 2002.In 2002, two customers, Park University and the U.S. Department of VeteransAffairs accounted for approximately 31% and 11% of the Company’s revenues,respectively.**** The Company currentlyanticipates that future revenues may be derived from sales to a limited numberof customers. Accordingly, the cancellation, non-renewal or deferral of a smallnumber of contracts could have a material adverse effect on the Company.

 

**Sales and Marketing**

 

The Company’s primarymarketing goals are to identify and attract organizations that offer largepotential relationships with the Company. VCampus is targeting industries andorganizations that require mandatory training, reach a large potential audienceand are well served by the Company’s e-Learning solutions. Primary markets includethe federal government, the healthcare, insurance, financial services/banking,pharmaceuticals and manufacturing industries, and institutes of highereducation offering extensive adult distance learning.

 

In addition to directsales efforts, the Company markets its products and services through a varietyof means, including the Web, public relations, trade shows, direct mail, tradepublications, customers, resellers and strategic partners. The Company believesthat forming strategic marketing alliances with parties who will sell, promoteand market the Company’s products and services will be important for growth.

 

**Competition**

 

The market for onlineeducational and training products and services is highly competitive and willlikely intensify. Although VCampus believes it was the first company to offerWeb-based, interactive, on-demand content, there are no substantial barriers toentry in the online education and training market. Competition in thedeveloping market for online training and education is based upon variousfactors, including quality, breadth and depth of content, marketing and thirdparty relationships, quality, flexibility, reliability of delivery system andpricing.

 

A number of companies,including SkillSoft, Click2learn, DigitalThink, Saba and Docent compete in thismarket, as well as many others. In addition to traditional classroom anddistance learning providers, other institutions such as Apollo Group (throughUniversity of Phoenix Online) offer their own accredited courses online or inan e-mail-based format. They, and many other education providers, use some ofthe Company’s methods, including e-mail, bulletin boards, threaded discussionand electronic conferencing, as well as other delivery methods such assatellite communications and audio and videotapes.

 

Management believes thatit is becoming increasingly apparent that e-learning providers must not onlyremain technologically advanced but also, more importantly, offer “complete”solutions. This “complete solution” approach includes offering customers accessto a large library of high quality, off-the-shelf courses; the ability toproduce customized courses quickly and effectively; and value-added featuresthat allow flexibility and scalability, thereby maintaining the learner as thenumber one proponent. Additionally, successful e-learning solutions must beaffordable, convenient and easy to use and administer.

 

Although there is a broadrange of approaches to the e-learning marketplace, most can be generallycategorized as follows, though several companies are active in more than onesegment:

 

ASP HostedServices: Provide consolidated access to learning andtraining from multiple sources by aggregating, hosting and distributingcontent.

Examples:  VCampus, GeoLearning, Docent, Saba,Click2learn and KnowledgePlanet.

 

Technology,Software, Learning Management System (LMS): Provide specificsoftware tools and infrastructure to companies that typically implementtechnology and applications behind a corporate firewall.  These are usually sold under a one-time,non-annuity license/maintenance model.

Examples: Saba, Docent,WBT Systems, Pathlore and Plateau Systems.

 

Content:Create the e-learning courses used to train corporate employees. Contenttypically falls into one of the three generic categories: informationtechnology, soft skills and customized content.  Leading content providers often provide support services inconjunction with their content.

Examples:  SkillSoft, DigitalThink, Element K,ExecuTrain, Learning Tree International and New Horizons.

 

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ProfessionalServices and Consulting: Provide consulting, implementationand support services, contract content development and distribution.

Examples:  Intellinex, DigitalThink and Collegis.

 

Most of the Company’scompetitors have significantly greater financial, technical and marketingresources than the Company. The Company will require financing to competeeffectively in this rapidly evolving market. In addition, any of thesecompetitors may be able to respond more quickly than the Company to new oremerging technologies and to devote greater resources to the development,promotion and sale of their services. A number of the Company’s currentcustomers and partners have also established relationships with certain of theCompany’s competitors, and future customers and partners may establish similarrelationships. In addition, the Company’s partners could use informationobtained from the Company to gain an additional competitive advantage over theCompany. The Company’s competitors may develop products and services that aresuperior to those of the Company or that achieve greater market acceptance thanthe Company’s products and services.

 

**Government Regulation and Legal Uncertainties**

 

The Company is notcurrently subject to direct regulation by any government agency, other thanregulations generally applicable to businesses, and there are currently fewlaws or regulations directly applicable to access or to commerce on onlinenetworks. Due to the increasing popularity and use of online networks, it ispossible that a number of laws and regulations may be adopted with respect toonline networks, covering issues such as user privacy, pricing, taxation and/orthe characteristics and quality of products and services. The adoption of any suchlaws or regulations may decrease the growth of online networks, which could inturn decrease the demand for the Company’s products and increase the Company’scost of doing business or otherwise have an adverse effect on the Company.Moreover, the applicability to online networks of existing laws governingissues such as intellectual property ownership, sales taxes, libel and personalprivacy is uncertain. Furthermore, as a publisher of educational materials, theCompany could be subject to accreditation or other governmental regulations.Any new legislation or regulation applicable to online networks, the Company orits products or services could have a material adverse effect on the Company.

 

Because materials may bedownloaded by the online or Internet services operated or facilitated by theCompany or the Internet access providers with which it has a relationship andbe subsequently distributed to others, there is a potential that claims will bemade against the Company for copyright or trademark infringement or based onother legal theories. Such claims have been brought against online services inthe past. Although the Company carries general liability insurance, theCompany’s insurance may not cover claims of this type, or may not be adequateto cover all liability that may be imposed. Any imposition of liability that isnot covered by insurance or is in excess of insurance coverage could have amaterial adverse effect on the Company.

 

**Trademarks and Proprietary Rights**

 

The Company regards itscopyrights, trademarks, trade dress, trade secrets and similar intellectualproperty as critical to its success, and the Company relies upon federalstatutory as well as common law copyright and trademark law, trade secretprotection and confidentiality and/or license agreements with its employees,customers, partners and others to protect its proprietary rights. The Companyowns registered trademarks in the United States for The e-Learning SolutionProvider, Teletutor, The Chalkboard, VCampus, the VCampus logo, VCampus.com,Take It Online, Point Page, and Course Construction Set.  Additionally, the Company has applied forregistration in the United States for certain of its other trademarks,including ContentMatters.

 

**Employees**

 

As of December 31, 2002,the Company had 48 employees, consisting of 12 full-time employees in generalbusiness operations, 15 full-time employees in sales and marketing, 13full-time employees in product development, and eight full-time employees ingeneral and administrative. None of the Company’s employees is represented by aunion and there have been no work stoppages. The Company believes that its employee relations are good.

 

**Risksand Uncertainties**

 

This report containsforward-looking statements that involve risks and uncertainties. Our actualresults could differ materially from those discussed in this report. Factorsthat could cause or contribute to these differences include, but are notlimited to, those discussed below and elsewhere in this report and in anydocuments incorporated in this report by reference.

 

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***We have incurred losses and anticipate future losses. ***We have incurredsignificant losses since our inception in 1984, including net lossesattributable to common stockholders of $14.0 million, $6.6 million and $7.1 forthe years ended December 31, 2000, 2001 and 2002. As of December 31, 2002, wehad an accumulated deficit of $84.2 million, stockholders’ equity of $1.6million and a working capital deficit of $0.8 million.  We expect losses from operations to continueuntil our online revenue stream matures. For these and other reasons, we cannotassure you that we will ever operate profitably.

 

***We may not be able to meet our business objective. ***Our key objective isto be the leading service provider of integrated e-learning solutions. Pursuingthis objective may significantly strain our administrative, operational andfinancial resources. We cannot assure you that we will have the operational,financial and other resources to the extent required to meet our online businessobjective.

 

***We will need to raise additional capital. ***If we are not able togenerate sufficient cash for ongoing operations, we will need to raiseadditional funds through public or private sale of our equity or debtsecurities or from other sources for the following purposes:

 

• to build our core online business;

 

• to fund our operating expenses; and

 

• to maintain compliance with Nasdaqlisting requirements.

 

We cannot assure you thatadditional funds will be available if and when we need them, or that if fundsare available, they will be on terms favorable to us and our stockholders. Ifwe are unable to obtain sufficient funds or if adequate funds are not availableon terms acceptable to us, we may be unable to meet our business objectives. Alack of sufficient funds could also prevent us from taking advantage ofimportant opportunities or being able to respond to competitive conditions. Anyof these results could have a material adverse effect on our business,financial condition and results of operations.

 

Our need to raiseadditional funds could also directly and adversely affect your investment inour common stock in another way. When a company raises funds by issuing sharesof stock, the percentage ownership of the existing stockholders of that companyis reduced, or diluted. If we raise funds in the future by issuing additionalshares of stock, you may experience significant dilution in the value of yourshares. Additionally, certain types of equity securities that we have issued inthe past and may issue in the future do have and could have rights, preferencesor privileges senior to your rights as a holder of our common stock.

 

***We face uncertainties and risks relating to our NasdaqSmallCap Market listing. ***Ourcommon stock is currently listed on the Nasdaq SmallCap Market. Nasdaq hascertain requirements that a company must meet in order to remain listed on theNasdaq SmallCap Market. In February 2002, Nasdaq notified us that we were notin compliance with the minimum bid price requirement for continued listing onthe Nasdaq SmallCap Market.  In June2002, we implemented a 1-for-10 reverse stock split in an effort to regaincompliance with the minimum bid price requirement.  After effecting the reverse stock split, Nasdaq notified us thatwe had regained compliance with the minimum bid price requirement.  On March 26, 2003, 2003, the closing bidprice of our common stock was $3.24 per share. Nevertheless, we may be unable to maintain our bid price above theminimum bid price requirement required for continued listing on the NasdaqSmallCap Market.  In addition, if wecontinue to experience losses from our operations or if we are unable to raiseadditional funds as needed, we may not be able to maintain compliance with theminimum $2.5 stockholders’ equity requirement for continued listing on theNasdaq SmallCap Market. At December 31, 2002, our stockholders’ equity was$1.65 million and $2.52 million on a pro forma basis as of December 31, 2002after giving effect to the Series G financing completed in the first quarter of2003.

 

The Nasdaq SmallCapMarket and the Nasdaq Over-the-Counter Bulletin Board are significantly lessactive markets than the Nasdaq National Market. You could find it moredifficult to dispose of your shares of our common stock than if our commonstock were listed on the Nasdaq National Market.

 

If our common stock weredelisted from the Nasdaq SmallCap Market, it could be more difficult for us toobtain other sources of financing in the future. Moreover, if our common stockwere delisted from the Nasdaq SmallCap Market, our stock could be subject towhat are known as the “penny stock” rules. The “penny stock” rules placeadditional requirements on broker-dealers who sell or make a market in suchsecurities. Consequently, if we were removed from the Nasdaq SmallCap Market,the ability or willingness of broker-dealers to sell or make a market in ourcommon stock could decline. As a result, your ability to resell your shares,and the price at which you could sell your shares, of our common stock could beadversely affected.  At December 31,2002, the Company had total equity of $1,647,805, which is below the minimumNasdaq SmallCap Market listing requirement of $2,500,000.

 

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If our common stock weredelisted from the Nasdaq SmallCap Market, it could be more difficult for us toretain existing and obtain new customers. The ability to continue and form newstrategic relationships may be negatively impacted. As a result, delistingcould result in a negatively impact our customer base and revenue.

 

***The large number of our shares eligible for future salecould have an adverse impact on the market price of our common stock.***Alarge number of shares of common stock already outstanding, along with sharesissuable upon exercise of options or warrants or conversion of preferred stockand convertible notes, is eligible for resale, which may adversely affect themarket price of our common stock.  As ofDecember 31, 2002, we had 1,573,904 shares of common stock outstanding, anadditional 1,877,749 shares were issuable upon conversion of outstandingpreferred stock, another 64,285 shares were issuable upon conversion ofconvertible notes and another 1,408,776 shares upon exercise of outstandingwarrants and options. Substantially all of the shares subject to outstandingwarrants and options will, when issued upon exercise, be available forimmediate resale in the public market pursuant to currently effectiveregistration statements under the Securities Act of 1933, as amended, orpursuant to Rule 701 or Rule 144 promulgated thereunder. Some of the sharesthat are or will be eligible for future sale have been or will be issued atdiscounts to the market price of our common stock on the date of issuance. Thenumber of shares of common stock issuable upon exercise of several classes ofour preferred stock has increased as a result of antidilution rights triggeredby recent financings. Resales or the prospect of resales of these shares mayhave an adverse effect on the market price of our common stock.

 

***We substantially depend on third-party relationships. ***We rely on maintainingand developing relationships with customers, academic and governmentinstitutions and businesses that provide content for our products and servicesand with companies that provide the Internet and related telecommunicationsservices used to distribute our products and services to customers.

 

We have relationshipswith a number of customers, academic institutions and businesses that provideus with course content for our online products and services. Some of theagreements we have entered into with these content providers limit our use oftheir course content, some do not cover use of any future course content andmost may be terminated by either party upon breach or bankruptcy. Our ASP-basedbusiness model is not compatible with the business models of certain contentproviders which may lead them to terminate the future licensing of existing andnew course content to us or fail to make this content available to us atcommercially reasonable rates or terms necessary for success under our businessmodel. Given our plans to introduce additional online courses in the future, wewill need to license new course content from existing and prospective contentproviders. However we might not be able to maintain and modify, if necessary,our existing agreements with content providers, or successfully negotiateagreements with prospective content providers. If the fees we pay to acquire ordistribute content increase, our results of operations could be adverselyaffected. We might not be able to license course content at commerciallyreasonable rates or at all.

 

We depend heavily onthird-party providers of Internet and related telecommunications services. Inorder to reach customers, our products and services have to be compatible withthe web browsers they typically use. Our customers have access to us throughtheir arrangements with Internet service providers.

 

For the customers,academic and government institutions and businesses that provide content forour products and services, the companies that provide the Internet and relatedtelecommunications services used to distribute our products and services tocustomers, and the web-site operators that provide links to our companyweb-sites, we cannot assure you that:

 

• they regard their relationships withus as important to their own businesses and operations;

 

• they will not reassess theircommitment to our products or services at any time in the future;

 

• they will not develop their own competitiveproducts or services;

 

• the products or services by whichthey provide access or links to our products or services will achieve marketacceptance or commercial success; or

 

• our relationships with them willresult in successful product or service offerings or generate significantrevenues.

 

If one or more of theseentities fail to achieve or maintain market acceptance or commercial success,or if one or more of the entities that do succeed decide to end theirrelationship with us, it could have a material adverse effect on our company.

 

***We operate in a highly competitive industry and may not beable to compete effectively. ***Themarket for educational and training products and services is highly competitiveand we expect that competition will continue to intensify. There are no

 

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substantial barriers to entry into our business, and we expect thatestablished and new entities will enter the market for online educational andtraining products and services in the near future.

 

A number of our existingcompetitors, as well as a number of potential new competitors (including someof our strategic partners), have longer operating histories, greater namerecognition, larger customer bases, more diversified lines of products andservices and significantly greater resources than we do. Such competitors maybe able to undertake more extensive marketing campaigns, adopt more aggressivepricing policies and make more attractive offers to potential customers.Recently, we have noticed that some of the more widely available online courseofferings, particularly those targeted to the corporate training market, areincreasingly competing primarily on price, which commoditization drives downmargins for all competitors in our industry. In competing against us, our strategicpartners could use information obtained from us to gain an additionalcompetitive advantage over us. Our current and potential competitors mightdevelop products and services that are superior to ours or that achieve greatermarket acceptance than ours. We might not compete effectively and competitivepressures might have a material adverse effect on our business, financialcondition and results of operations.

 

As the revenue potentialfor online delivery of educational and training courses continues to grow, themarket is likely to attract a number of large, well capitalized competitorsseeking to diversify their revenue streams into this market. Not only will someof these potential competitors be well capitalized and be willing to operate inthe market at a loss to build market share, they may also acquire and/orsubstantially fund our other competitors which might have a material adverseeffect on our business, financial condition and results of operations.

 

***We depend on key personnel. ***Our future success depends on the continuedcontributions of our key senior management personnel, some of whom have workedtogether for only a short period of time. We do not maintain “key man” lifeinsurance on any of our executive officers. The loss of services of any of ourkey management personnel, whether through resignation or other causes, or theinability to attract qualified personnel as needed, could have a materialadverse effect on our financial condition and results of operation.

 

***We anticipate significant fluctuations in our quarterlyresults. ***Ourexpense levels are based in part on our expectations as to future revenues.Quarterly sales and operating results generally depend on the online revenuesand development and other revenues, which are difficult to forecast. Inaddition, past results have shown our business to be subject to a materialadverse seasonality associated with the large number of holidays in thecalendar fourth quarter. We may not be able to adjust spending in a timelymanner to compensate for any unexpected revenue shortfall. Accordingly, anysignificant revenue shortfall would have an immediate adverse impact on ourbusiness and financial condition.

 

Our operating results mayfluctuate significantly in the future as a result of a variety of factors, someof which are outside of our control. These factors include:

 

• demand for online education;

 

• the budgeting cycles of customers;

 

• seasonality of revenuescorresponding to academic calendars;

 

• capital expenditures and other costsrelating to the expansion of operations;

 

•the introduction of new products or services by us or our competitors;

 

•the mix of the products and services sold and the channels through which thoseproducts and services are sold;

 

• pricing changes; and

 

• general economic conditions.

 

As a strategic responseto a changing competitive environment, we may elect from time to time to makecertain pricing, service or marketing decisions that could have a materialadverse effect on us. We believe that period-to-period comparisons of ouroperating results should not be relied upon as an indication of futureperformance. Due to all of the foregoing factors, it is possible that in somefuture quarter, our operating results will be below the expectations of publicmarket analysts and investors. In such event, the price of our common stockwould likely be materially and adversely affected.

 

***We rely on significant customers. ***A significant portion of our revenues isgenerated by a limited number of customers. We expect that we will continue todepend on large contracts with a limited number of significant customersthrough the near

 

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future. This situation can cause our revenue and earnings to fluctuatebetween quarters based on the timing of contracts. Most of our customers haveno obligation to purchase additional products or services from us. Furthermore,VCampus has been notified that the GSA (General Services Administration of theUnited States) will be terminating its VCampus contract in April 2003. Thistermination decision was reached to enable GSA to comply with a request fromthe OPM (Office of Personnel Management) and the OMB (Office of Management andBudget) that GSA consolidate its e-learning with e-learning campus hosted by acompetitor.  As of the date of thisreport, no other federal government customers of VCampus have indicated thatthey intend to move their business to this government-approved competitor;however, VCampus could face similar loss of government customers due to theattempts by OPM and OMB to centralize the federal government’s e-learningpurchases with this competitor. Consequently, if we fail to developrelationships with significant new customers, our business, financial conditionand results of operations will be materially and adversely affected.

 

***We face the risk of system failures and capacityconstraints. ***Akey element of our strategy is to generate a high volume of online traffic toour products and services. Accordingly, the performance of our products andservices is critical to our reputation, our ability to attract customers andmarket acceptance of our products and services. Any system failure that causesinterruptions in the availability or increases response time of our productsand services would result in less usage of our products and services and,especially if sustained or repeated, would reduce the attractiveness of ourproducts and services. An increase in the volume of use of our products andservices could strain the capacity of the software or hardware we use or thecapacity of our network infrastructure, which could lead to slower responsetime. Any failure to expand the capacity of our hardware or networkinfrastructure on a timely basis or on commercially reasonably terms would havea material adverse effect on our business. We also depend on web browsers andInternet service providers for access to their products and services, and usersmay experience difficulties due to system failures unrelated to our systems,products and services.

 

***We face security risks. ***We include in our products certain securityprotocols that operate in conjunction with encryption and authenticationtechnology. Despite these technologies, our products may be vulnerable tobreak-ins and similar disruptive problems caused by online users. Such computerbreak-ins and other disruptions would jeopardize the security of informationstored in and transmitted through our computer systems and the computer systemsof end-users, which may result in significant liability for us and may alsodeter potential customers. For example, computer “hackers” could remove oralter portions of our online courseware. Persistent security problems continueto plague the Internet, the Web and other public and private data networks.Alleviating problems caused by third parties may require us to make significantexpenditures of capital and other resources and may cause interruptions, delaysor cessation of service to our customers and to us. Moreover, our security andprivacy concerns and those of existing and potential customers, as well asconcerns related to computer viruses, may inhibit the growth of the onlinemarketplace generally, and our customer base and revenues in particular. Weattempt to limit our liability to customers, including liability arising from afailure of the security features contained in our products, through contractualprovisions limiting warranties and disallowing damages in excess of the pricepaid for the products and services purchased. However, these limitations mightnot be enforceable. We maintain liability insurance to protect against theserisks however this insurance may be inadequate or may not apply in certainsituations.

 

***We face an undeveloped and rapidly changing market for ourproducts and services. ***Themarket for our products and services is rapidly evolving in response to recentdevelopments relating to online technology. The market is characterized byevolving industry standards and customer demands and an increasing number ofmarket entrants who have introduced or developed online products and services.It is difficult to predict the size and growth rate, if any, of this market. Asis typical in the case of a rapidly evolving industry, demand and marketacceptance for recently introduced products and services are subject to a highlevel of uncertainty. Our future success will depend in significant part on ourability to continue to improve the performance, features and reliability of ourproducts and services in response to both evolving demands of the marketplaceand competitive product offerings, and we cannot assure that we will besuccessful in developing, integrating or marketing such products or services.In addition, our new product releases may contain undetected errors thatrequire significant design modifications, resulting in a loss of customerconfidence and adversely affecting our business.

 

***There are risks relating to our intellectual propertyrights. ***We regardour copyrights, trademarks, trade dress, trade secrets and similar intellectualproperty as critical to our success, and we rely upon trademark and copyrightlaw, trade secret protection and confidentiality and/or license agreements withour employees, customers, partners and others to protect our proprietaryrights.

 

We have had certaintrademark applications denied and may have more denied in the future. We willcontinue to evaluate the need for registration of additional marks asappropriate. Despite our efforts to protect our proprietary rights,unauthorized parties may attempt to copy aspects of our products or services orto obtain and use information that we regard as proprietary. In addition, thelaws of some foreign countries do not protect proprietary rights to as great anextent as do the laws of the United States. Litigation may be necessary to protectour proprietary technology. Any such litigation may be time-consuming andcostly, cause product release delays, require us to redesign our products orservices or require us to enter into royalty or licensing agreements, any ofwhich could have a material adverse effect upon us. These royalty or licensingagreements, if required, may not

 

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be available on terms acceptable to us or at all. Our means ofprotecting our proprietary rights might not be adequate and our competitorsmight independently develop similar technology, duplicate our products orservices or design around patents or other intellectual property rights wehave. In addition, distributing our products through online networks makes oursoftware more susceptible than other software to unauthorized copying and use.For example, online delivery of our courseware makes it difficult to ensurethat others comply with contractual restrictions, if any, as to the parties whomay access such courseware. If, as a result of changing legal interpretationsof liability for unauthorized use of our software or otherwise, users were tobecome less sensitive to avoiding copyright infringement, we could bematerially adversely affected.

 

***We face government regulation and legal uncertainties. ***There are currentlyfew laws or regulations that directly apply to activities on the Internet. Webelieve that we are not currently subject to direct regulation by anygovernment agency in the United States, other than regulations that aregenerally applicable to all businesses. A number of legislative and regulatoryproposals are under consideration by federal and state lawmakers and regulatorybodies and may be adopted with respect to the Internet and/or online deliveryof course content. Some of the issues that these laws and regulations may coverinclude user privacy, pricing and characteristics and quality of products andservices. The adoption of any such laws or regulations may decrease the growthof the Internet, which could in turn decrease the projected demand for ourproducts and services or increase our cost of doing business. The applicabilityto the Internet of existing U.S. and international laws governing issues suchas property ownership, copyright, trade secret, libel, taxation and personalprivacy is uncertain and developing. Any new legislation or regulation, orapplication or interpretation of existing laws, could have a material adverseeffect on our business, results of operations, financial condition andprospects.

 

***We could issue preferred stock and take other actions thatmight discourage third parties from acquiring us. ***Our board of directors has the authority,without further action by the stockholders, to issue up to 10,000,000 shares ofpreferred stock and to fix the rights, preferences, privileges andrestrictions, including voting rights, of such shares. We currently haveoutstanding seven classes of preferred stock. The rights of the holders of thecommon stock are subject to the rights of the holders of our outstandingpreferred stock, and will be subject to, and may be adversely affected by, therights of the holders of any preferred stock that may be issued in the future.Issuing preferred stock could have the effect of making it more difficult for athird party to acquire a majority of our outstanding voting stock, therebydelaying, deferring or preventing a change in control of our company.Furthermore, the preferred stock may have other rights, including economicrights, senior to our common stock, and as a result, issuing preferred stockcould have a material adverse effect on the market value of our common stock.

 

Certain provisions of ourcertificate of incorporation and our bylaws could make it more difficult for athird party to acquire, and could discourage a third party from attempting toacquire, control of our Company. Some of them eliminate the right ofstockholders to act by written consent and impose various procedural and otherrequirements which could make it more difficult for stockholders to undertakecertain corporate actions. These provisions could limit the price that certaininvestors might be willing to pay in the future for shares of our common stockand may have the effect of delaying or preventing a change in control of ourCompany. We may in the future adopt other measures that may have the effect ofdelaying, deferring or preventing a change in control of our Company. Certainof these measures may be adopted without any further vote or action by thestockholders, although we have no present plans to adopt any such measures. Weare also afforded the protections of Section 203 of the Delaware GeneralCorporation Law, which could delay or prevent a change in control of ourCompany, impede a merger, consolidation or other business combination involvingour company or discourage a potential acquirer from making a tender offer orotherwise attempting to obtain control of our Company.

 

***We might not be able to use net operating losscarryforwards. ***Asof December 31, 2002, we had net operating loss carryforwards for federalincome tax purposes of approximately $56 million, which will expire at variousdates through 2022. Our ability to use these net operating loss and creditcarryforwards to offset future tax obligations, if any, may be limited bychanges in ownership. Any limitation on the use of net operating losscarryforwards, to the extent it increases the amount of federal income tax thatwe must actually pay, may have an adverse impact on our financial condition.

 

***We do not presently anticipate payingcash dividends on our common stock.***  Weintend to retain all earnings, if any, for the foreseeable future for fundingour business operations.  In addition,our outstanding preferred stock contains restrictions on our ability to declareand pay dividends on our common stock. Consequently, we do not anticipate paying any cash dividends on ourcommon stock for the foreseeable future.

 

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**Item 2.  * *Properties.**

 

A current summary showingthe operating properties of the Company, all of which are leased, is shownbelow:

 
| **Location**      |   | **Principal  Use**                                                                        |   | **Area  (Square Feet)** |   | **Lease  Expiration  Date** |   | **Monthly  Rent** |   |
|-------------------|--------|-------------------------------------------------------------------------------------------|--------|-------------------------|--------|-----------------------------|--------|-------------------|--------|
| Reston,  VA       |   | Executive offices and  principal administration, technical marketing and sales operations |   | 16,701                  |   | February 2010               |   | $ 40,235          | (1)    |
|              |   |                                                                                      |   |                    |   |                        |   |              |   |
| Rockville,  MD(2) |   | HTR executive offices                                                                     |   | 6,222                   |   | January 2006                | (3)    | 13,043            | (1)    |

 

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(1) Subject to 3% annualincreases

(2) Aspart of the Company’s transition to focus exclusively on its online businesses,the Company is negotiating to terminate this lease. See “Item 3. Legal Proceedings”below for a discussion of the Company’s obligations under this lease.

(3)The Company has the option to terminate this lease in December 2003, if theCompany is not in default. However, as of the date of this report the landlordclaims the Company is in default under the lease for non-payment of rents.The Company disputes this claim and has attempted to remit the portion of thelease payments it believes will cure the default.  See “Item 3. LegalProceedings” below for a discussion of the legal proceedings relating to thelease.

 

The Company believes thatits existing office space is sufficient to accommodate its current needs andthat suitable additional space will be available on commercially reasonableterms to accommodate any expansion needs in 2003 should the need arise.

 

**Item 3.  Legal Proceedings*.***

 

The Virginia Departmentof Taxation recently completed an audit of VCampus’ sales and use tax paymentsfrom August 1998 through October 2001. In July 2002, the Company received a draft assessment which contemplateda payment of taxes, penalties and interest by VCampus of $212,719, primarilyassociated with the alleged failure of VCampus to assess use tax on third-partyroyalties paid by VCampus to content providers for courses delivered online bythe Company. This preliminary assessment was not yet a formal, bindingassessment by the Virginia Department of Taxation. The Company paid the salesand use tax, and interest on non-contested items, which amounted to $18,928 outof the $212,719. The Company has formally contested the remaining items coveredby the draft assessment, including the assessment of use tax on the royaltiespaid by VCampus to content providers for courses delivered online by theCompany. The Company is also contesting the methodology used by the VirginiaDepartment of Taxation to estimate the royalties. The Company does not have afirm estimate of the probability of liability for this issue or the amount ofanticipated legal costs, but has reason to believe that the potential liabilitywill be reduced to the point where it will not be considered material.Accordingly, the Company cannot estimate at this time the amount of theliability to be incurred, if any. No amounts have been accrued in the financialstatements for this potential liability.

 

On June 26, 2002, aformer employee (separated in June 1998) filed suit against the Company inDallas County, Texas. The suit alleges damages in the following amounts: anallegedly earned unpaid bonus of $56,250, $231,250 based on an alleged changeof control in the Company and $360,000 for the Company’s alleged failure toallow him to exercise stock options. The Company has rejected this formeremployee’s claims several times in the past after thorough investigations, andthe Company continues to believe these claims are without merit and plans tovigorously defend against them. The case was subject to mediation in December2002, which failed to produce a settlement. The case is scheduled for trial inSeptember 2003.  The plaintiff filed amotion for summary judgment on the issue of the unpaid bonus, which is expectedto be heard shortly. The Company at this time cannot provide a definitiveestimate of legal fees required for the case; however they may become materialas the case progresses. The Company cannot estimate at this time the amount orprobability of the liability to be incurred, if any. Accordingly, no amountshave been accrued in the financial statements.

 

In March 2003, theMontgomery County, Maryland Circuit Court issued an order for VCampus to payits landlord in Rockville, Maryland $93,453 of back rent due and all futurerents ($499,535) less any rents received by the landlord from any re-leasing ofthe premises. The order calls for the future rent amount to be paid monthlythrough the end of the lease term in 2005. The Company plans to contest theliability for future rents beyond December 2003 ($323,231) per the lease terms.The liability for back rents and rents through December 2003 and attorneys’fees is reflected on the Company’s balance sheet. The Company cannot estimateat this time the probability of the liability to be incurred, if any, for rentbeyond December 2003. Accordingly, no amounts have been accrued in thefinancial statements for this.

 

Although the Company isnot currently involved in any other material pending legal proceedings, theCompany could be subjectto legal proceedings and claims in the ordinary course of its business orotherwise, including claims relating to license agreements,

 

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royalties or claims ofalleged infringement of the trademarks and other intellectual property rightsof third parties by the Company and its licensees.

 

**Item 4.  Submission of Matters toa Vote of Security Holders.**

 

Nomatters were submitted to a vote of security holders during the fourth quarterended December 31, 2002.

 

##### **ExecutiveOfficers**

 

As of March 26, 2003, theexecutive officers of the Company were as follows:

 
| **Name**               |   | **Age** |   | **Positions**                                                     |
|------------------------|--------|---------|--------|-------------------------------------------------------------------|
|                   |   |    |   |                                                              |
| Nat  Kannan            |   | 54      |   | Chief  Executive Officer                                          |
| Daniel  J. Neal        |   | 44      |   | Executive Vice Chairman                                           |
| Christopher  L. Nelson |   | 40      |   | Chief Financial  Officer, Chief Information Officer and Secretary |
| Ronald  E. Freedman    |   | 54      |   | Senior  Vice President, Worldwide Sales and Marketing             |

 

Mr. Kannan has served as VCampus’ Chairman of the Board of Directorssince he founded the Company in 1994 and he resumed the Chief Executive Officerposition in December 2002, a position he formerly held from 1984 to 2000. Priorto founding the Company, he founded IMSATT Corporation in 1984 and co-foundedGanesa Group, Inc., a developer of interactive graphics and modeling software,in 1981. He also served as a consultant to Booz Allen and Hamilton, Inc., theMITRE Corporation, The Ministry of Industry of the French Government, theBrookhaven and Lawrence Livermore National Laboratories, the White HouseDomestic Policy Committee on Energy and Control Data Corporation. He holds aB.S. in Engineering from the Indian Institute of Technology in Madras, India,and he performed advanced graduate work in business and engineering at DartmouthCollege.

 

Daniel J. Neal**has served as a director ofthe Company since joining the Company in September 2000.  From September 2000 until December 2002, Mr.Neal also served as VCampus’ CEO. Mr. Neal now serves as the Chief of StrategicPartnerships and Vice Chairman of the Board of Directors. From July 1998 untiljoining the Company, Mr. Neal served in various positions with US*internetworking*,Inc., including Vice President/General Manager, Senior Director, E-CommercePartnering and Senior Director, Acquisition Integration.  From April 1996 until July 1998, he was theDirector of National Partnering for Global One Communications, LLC, asubsidiary of Sprint.  Prior to that, Mr.Neal served as a Senior Staff Member with the Office of the Vice President of theUnited States.  Mr. Neal received hisB.A. from the University of California, Berkeley, and holds an M.B.A. from theWharton School at the University of Pennsylvania.

 

Christopher Nelson joined VCampus as Chief Financial Officer and ChiefInformation Officer in June of 2002. Mr. Nelson oversees the entire technology,operations and customer service areas of the business in addition to hisfinance and accounting department responsibilities. Prior to his appointment asVCampus CFO, Mr. Nelson was a Principal of Monticello Capital LLC, where headvised high-growth technology businesses and their corporate boards oncorporate finance, capitalization transactions, and mergers and acquisitions.Mr. Nelson has held positions as CEO, COO and CFO of niche, high tech companiesin the Internet space over the past several years (including Kignet, Inc.,Monumental Network Systems, and IMA Software, Inc.) during which he hasdeveloped particular expertise in bringing companies to cash flow positivepositions. Mr. Nelson has also held executive positions at NTT/Verio, as wellas sales and marketing and manufacturing positions at IBM Corporation. Mr.Nelson holds a Master of Business Administration from The Wharton School at theUniversity of Pennsylvania, and a Bachelor of Science degree in ChemicalEngineering from the University of Delaware. Mr. Nelson also previously servedas a George Mason Fellow, acting as an advisor to start-up and early stagetechnology companies on a volunteer basis through the TechVenture Partnershipat George Mason University.

 

Ronald E. Freedman is responsible for all sales and marketing programsat VCampus. Mr. Freedman has more than 20 years of hands-on experience in salesmanagement, strategic planning, business development, and execution of profitand loss responsibility. Mr. Freedman joined VCampus in 2001 fromUSinternetworking, Inc. (USi) where he was Vice President of InformationAssurance and Chief Security Officer. While at USi, he was responsible for thedesign, implementation, and management of the USi Total Security Architecture,a best-of-breed security portfolio. Prior to joining USi, Freedman was VicePresident of one of the business divisions at The Netplex Group, Inc. There, hewas responsible for sales, marketing and

 

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fulfillment of a wide range of technology-based products and services.Previously, Mr. Freedman was Vice President, Systems and Services for COMSISCorporation, where he managed the division of the professional services companyproviding contingency planning and information security services to commercialand government customers. He also served as Executive Vice President ofAdvanced Information Management, Inc., where he was responsible for marketingand delivering information security and contingency planning services toFortune 500 customers. Mr. Freedman worked for General Electric Company forfifteen years, most recently as General Manager, Disaster Recovery Services andManager, Strategic Planning and Business Development. He also served as aPresidential appointee, on loan to The White House from General Electric,responsible for developing contingency plans as part of the Continuity ofGovernment Program. He received a Presidential Commendation for outstandingservice during that assignment. Mr. Freedman holds a BA in Economics fromNortheastern University in Boston and an MBA in Management from Babson Collegein Wellesley, MA.

 

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##### **PARTII**

 

**Item 5.  Market for Registrant’sCommon Equity and Related Stockholder Matters.**

 

(a)*PriceRange of Common Stock*

 

Ourcommon stock is currently listed on the Nasdaq SmallCap Market under the symbol“VCMP.” For each full fiscal quarter since the beginning of 2001, the high andlow bid quotations for our common stock, adjusted to reflect the ten-for-onereverse stock split which occurred in July 2002 and as reported by Nasdaq, wereas follows:

 

|           |   | **High** |   | **Low** |   |
|----------------|--------|----------|--------|---------|--------|
| **2001**       |   |     |   |    |   |
| First quarter  |   | $        | 27.50  |    | $      | 5.30 |   |
| Second quarter |   | $        | 22.50  |    | $      | 6.30 |   |
| Third quarter  |   | $        | 17.00  |    | $      | 5.00 |   |
| Fourth quarter |   | $        | 8.50   |    | $      | 2.10 |   |
|           |   |     |   |    |   |
| **2002**       |   |     |   |    |   |
| First quarter  |   | $        | 7.70   |    | $      | 2.40 |   |
| Second quarter |   | $        | 6.50   |    | $      | 2.20 |   |
| Third quarter  |   | $        | 3.90   |    | $      | 2.06 |   |
| Fourth quarter |   | $        | 5.50   |    | $      | 2.25 |   |

 

Theforegoing bid quotations reflect inter-dealer prices, without retail mark-ups,mark-downs or commissions, and may not represent actual transactions.

 

Sincethe Company’s IPO in late 1996, the public market for the Company’s CommonStock has been characterized by low and/or erratic trading volume, oftenresulting in price volatility. There can be no assurance that there will be anactive public market for the Company’s Common Stock in the future. The marketprice of the Common Stock could be subject to significant fluctuations inresponse to future announcements concerning the Company or its partners orcompetitors, the introduction of new products or changes in product pricingpolicies by the Company or its competitors, proprietary rights or otherlitigation, general conditions in the e-learning market, developments in thefinancial markets and other factors. In addition, the stock market has, fromtime to time, experienced extreme price and volume fluctuations that haveparticularly affected the market prices for technology companies and which haveoften been unrelated to the operating performance of the affected companies.Broad market fluctuations of this type may adversely affect the future marketprice of the Common Stock. See “Item 7. Management’s Discussion and Analysis ofFinancial Condition and Results of Operations — Liquidity and CapitalResources.”

 

FromOctober 1, 2002 to December 31, 2002, the Company issued the followingunregistered securities:

 

(1)           42,733 shares of common stock, valued at $3.29 per share,were issued as a dividend to the holders of the Company’s Series D PreferredStock on December 31, 2002.

 

(2)           2,800 and 120 shares of Series G Preferred Stock at apurchase price of $24.90 per share (10 times the trailing five-dayaverage closing price of its common stock) to two accredited investors and aplacement agent, respectively.  Underthe terms of this financing, the Company also issued five-year fully vested warrants to purchase 7,000 and 300 shares of commonstock at $2.74 per share to the same accredited investors and placement agent,respectively.  Each share of Series G Preferred Stock is initiallyconvertible into 10 shares of common stock at any time at the election of theholder.

 

Thesales of the above securities were deemed to be exempt from registration underSection 4(2) of the Securities Act of 1933, as amended (the “Act”), in relianceupon the Act, or Regulation D promulgated thereunder, as transactions by anissuer not involving a public offering. Recipients of the securities in each such transaction represented theirintentions to acquire such securities for investment only and not with a viewto or for sale in connection with any distribution thereof and appropriatelegends were affixed to the instruments issued in such transactions.  All recipients had adequate access toinformation about the Company.

 

16

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(b)  *Approximate Number of Equity Security Holders*

 

Asof March 14, 2003, the number of record holders of the Company’s Common Stockwas 113 and the Company believes that the number of beneficial owners wasapproximately 1,200.

 

(c)  *Dividends*

 

TheCompany has never paid a cash dividend on its Common Stock and anticipates thatfor the foreseeable future any earnings will be retained for use in itsbusiness and, accordingly, does not anticipate the payment of cashdividends.  Future dividends, if any,will depend on, among other things, the Company’s results of operations,capital requirements and on such other factors as the Company’s Board ofDirectors, in its discretion, may consider relevant.

 

**Item 6.  Selected Financial Data.**

 

Thefollowing selected consolidated financial data should be read in conjunctionwith the consolidated financial statements and the notes thereto includedelsewhere herein. The consolidated statement of operations data set forth belowwith respect to the years ended December 31, 2000, 2001 and 2002 and theconsolidated balance sheet data as of December 31, 2001 and 2002 are derivedfrom, and are referenced to, the audited consolidated financial statements ofthe Company included elsewhere in this Annual Report on Form 10-K.  The consolidated statement of operationsdata set forth below with respect to the years ended December 31, 1998 and 1999and the consolidated balance sheet data as of December 31, 1998, 1999 and 2000are derived from financial statements not included in this Annual Report onForm 10-K.

 

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| **Statement of Operations Data:In thousands except per share data**  |   | **1998** |    | **1999** |   | **2000** |   | **2001** |    | **2002** |   |
|----------------------------------------------------------------------|--------|----------|---------|----------|--------|----------|--------|----------|---------|----------|--------|
|                                                                 |   |     |    |     |   |     |   |     |    |     |   |
| Net revenues:                                                        |   |     |    |     |   |     |   |     |    |     |   |
| Online tuition revenues                                              |   | $        | 1,549   |     | $      | 3,835    |   | $        | 5,065   |     | $      | 5,945 |   | $ | 5,606 |   |
| Virtual campus software revenues                                     |   | 112      |    | 216      |   | 115      |   | 72       |    | —   |   |
| Online development and other revenues                                |   | 926      |    | 977      |   | 1,022    |   | 687      |    | 496      |   |
| Product sales revenues                                               |   | 3,348    |    | 1,222    |   | 414      |   | 45       |    | —   |   |
| Other service revenues                                               |   | 2,445    |    | 305      |   | 175      |   | 122      |    | 100      |   |
| Instructor-led training revenues                                     |   | 6,303    |    | 4,992    |   | 2,665    |   | 102      |    | —   |   |
| Total net revenues                                                   |   | 14,683   |    | 11,547   |   | 9,456    |   | 6,973    |    | 6,202    |   |
| Costs and expenses:                                                  |   |     |    |     |   |     |   |     |    |     |   |
| Cost of revenues                                                     |   | 8,869    |    | 5,749    |   | 3,296    |   | 1,093    |    | 1,462    |   |
| Sales and marketing                                                  |   | 5,304    |    | 4,286    |   | 6,242    |   | 4,717    |    | 2,965    |   |
| Product development and operations                                   |   | 6,102    |    | 2,241    |   | 3,555    |   | 2,273    |    | 2,536    |   |
| General and administrative                                           |   | 3,783    |    | 2,633    |   | 2,761    |   | 2,045    |    | 1,693    |   |
| Depreciation and amortization                                        |   | 3,347    |    | 2,956    |   | 2,916    |   | 2,154    |    | 1,356    |   |
| Compensation expense in connection with the  acquisition of HTR, Inc |   | —   |    | 1,089    |   | 654      |   | —   |    | —   |   |
| Reorganization and other non-recurring  charges                      |   | 5,585    |    | 360      |   | 2,261    |   | 188      |    | 192      |   |
| Stock-based compensation                                             |   | —   |    | —   |   | 361      |   | 441      |    | 76       |   |
| Total costs and expenses                                             |   | 32,990   |    | 19,314   |   | 22,046   |   | 12,911   |    | 10,280   |   |
|                                                                 |   |     |    |     |   |     |   |     |    |     |   |
| Loss from operations                                                 |   | (18,307  | )       | (7,767   | )      | (12,590  | )      | (5,938   | )       | (4,078   | )      |
|                                                                 |   |     |    |     |   |     |   |     |    |     |   |
| Other income (expense):                                              |   |     |    |     |   |     |   |     |    |     |   |
| Gain (loss) on sale of subsidiaries                                  |   | (907     | )       | 1        |   | —   |   | —   |    | —   |   |
| Other income                                                         |   | —   |    | —   |   | —   |   | —   |    | 422      |   |
| Interest income (expense)                                            |   | (597     | )       | (721     | )      | 166      |   | 5        |    | (220     | )      |
| Loss on debt extinguishments                                         |   | —   |    | —   |   | —   |   | —   |    | (503     | )      |
| Cumulative effect of accounting change                               |   | —   |    | —   |   | (461     | )      | —   |    | —   |   |
| Net loss                                                             |   | $        | (19,811 | )        | $      | (8,487   | )      | $        | (12,885 | )        | $      | (5,933 | ) | $ | (4,379 | ) |
| Dividends to preferred stockholders                                  |   | (358     | )       | (448     | )      | (1,153   | )      | (649     | )       | (2,768   | )      |
| Net loss attributable to common stockholders                         |   | $        | (20,169 | )        | $      | (8,935   | )      | $        | (14,038 | )        | $      | (6,582 | ) | $ | (7,147 | ) |
| Net loss per share                                                   |   | $        | (52.70  | )        | $      | (19.10   | )      | $        | (17.65  | )        | $      | (5.23 | ) | $ | (4.79 | ) |
| Net loss per share - assuming dilution                               |   | $        | (52.70  | )        | $      | (19.10   | )      | $        | (17.65  | )        | $      | (5.23 | ) | $ | (4.79 | ) |

 
|                            |   | **1998** |   | **1999** |   | **2000** |   | **2001** |   | **2002** |   |
|---------------------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------|--------|
| **Balance Sheet Data:**         |   |     |   |     |   |     |   |     |   |     |   |
| Working capital deficit         |   | $        | (4,631 | )        | $      | (5,155   | )      | $        | (2,036 | )        | $      | (885 | ) | $ | (828 | ) |
| Total assets                    |   | 14,871   |   | 10,668   |   | 6,652    |   | 7,012    |   | 4,373    |   |
| Total liabilities               |   | 9,051    |   | 8,646    |   | 3,620    |   | 4,198    |   | 2,725    |   |
| Accumulated deficit             |   | (47,697  | )      | (56,632  | )      | (70,585  | )      | (77,060  | )      | (84,207  | )      |
| Total stockholders’ equity |   | 5,820    |   | 2,022    |   | 3,031    |   | 2,814    |   | 1,648    |   |
|                                 |        |          |        |          |        |          |        |          |        |          |        |  |  |  |  |  |

 

Pershare amounts for all periods presented have been adjusted to reflect theone-for-ten reverse stock split which occurred in July 2002.

 

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**Item 7.  Management’sDiscussion and Analysis of Financial Condition and Results of Operation.**

 

From time to time, asused herein, the term “Company” or “VCampus” shall mean VCampus Corporation andits subsidiaries: Cognitive Training Associates, Inc., a Texas corporation;Cooper & Associates, Inc., an Illinois corporation, d/b/a Teletutor; HTR,Inc., a Delaware corporation; and UOL Leasing, Inc., a Delaware corporation.

 

The followingpresentation of management’s discussion and analysis of the Company’sconsolidated financial condition and results of operation should be read inconjunction with the Company’s consolidated financial statements, accompanyingnotes thereto and other financial information appearing elsewhere in thisreport.

 

**Overview**

 

In 2002, the Company’srevenues were derived from three primary sources:

 

• online tuition revenues;

 

• development revenues; and

 

• other service revenues;

 

Online tuition revenuesare generated primarily from online tuition derived from corporate, government,and higher education customers. Development revenues consist primarily of feespaid to the Company for creating and developing new online courseware andweb-enabling existing courseware. Other service revenues consist primarily ofmonthly fees generated by the maintenance of the CYBIS courseware undercontract with the U.S. Army.

 

During 1998, the Companychanged its pricing model from a platform license fee for hosting services toan ASP service fees and subscription model based on course usagecommitments.  This pricing structureprovides a lower cost of entry and generates a recurring revenue stream forVCampus.  While prior to 1997 licensingand support revenues have represented a substantial majority of the Company’srevenues, online related revenues currently comprise the vast majority of theCompany’s total revenues and the Company believes that online related revenueswill continue to be the primary source of its revenues in the future.

 

On June 18, 2002, theCompany’s Board of Directors approved a one-for-ten reverse stock split of theCompany’s common stock.  The reversestock split became effective as of the opening of trading on July 8, 2002.Stockholders’ equity has been restated to give retroactive recognition to thereverse stock split for all periods presented by reclassifying the excess parvalue resulting from the reduced number of shares from common stock topaid-in-capital.  All references tocommon share and per-share amounts for all periods presented have beenretroactively restated to reflect the stock split.

 

**Critical AccountingPolicies**

 

The preparation of theCompany’s consolidated financial statements in conformity with accountingprinciples generally accepted in the United States requires management to makeestimates and assumptions that affect the amounts reported in the consolidatedfinancial statements and accompanying notes. Actual results could differ materially from those estimates.  The Company’s accounting policies which aresignificantly affected by management’s estimates and assumptions are asfollows:

 

*RevenueRecognition*

 

TheCompany derives its revenues from the following sources — online tuitionrevenues, other service revenues and development and other revenues.

 

Revenueis recognized in accordance with either SEC Staff Accounting BulletinNo. 101, *Revenue Recognition in FinancialStatements* (SAB 101), as amended, or Statement of Position 97-2, *SoftwareRevenue Recognition* (“SOP 97-2”), as amended.   Both SAB 101 and SOP 97-2 generally require that four basiccriteria must be met before revenue can be recognized: (1) persuasive evidenceof an arrangement exists; (2) delivery has occurred or services rendered; (3)the fee is fixed and determinable: and (4) collectibility is reasonablyassured.  Determination of criteria (3)and (4) are based on management’s judgments regarding the fixed nature of thefee charged for services rendered and the collectibility of those fees.  Should changes in conditions causemanagement to determine these criteria are not met for certain sales, revenuerecognized for any reporting period could be adversely affected.

 

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Development and otherrevenues earned under courseware conversion contracts are recognized based onthe ratio that total costs incurred to date bear to the total estimated costsof the contract.  Management’s estimatesof total costs to complete contracts may be revised in future periods resultingin adjustments to revenue and profit recognized in the period the revisions aremade.

 

*Allowancefor Doubtful Accounts*

 

The Company maintainsallowances for doubtful accounts for estimated losses resulting from theinability of its customers to make required payments.  If the financial condition of those customers were todeteriorate, resulting in an impairment of their ability to make payments,additional allowances may be required in future periods.

 

*Goodwilland Other Identifiable Intangibles*

 

Management assesses therecoverability of goodwill and other identifiable intangibles whenever eventsor changes in circumstances indicate that the carrying value may not berecoverable.  When management determinesthat the carrying value of goodwill or other identifiable intangibles is notrecoverable, an impairment loss is recognized to the extent the carrying valueof the asset exceeds its fair value. Fair value can be estimated using a number of techniques includingquoted market prices, valuations by third parties and discounted cash flowanalysis.  The fair value of the assetcould be different using different estimates and assumptions in these valuationtechniques.

 

In accordance withStatement of Financial Accounting Standards No. 142, “Goodwill and OtherIntangibles,” the Company ceased amortizing of goodwill and otherindefinite-lived intangibles on January 1, 2002.  In lieu of amortization, these assets are subject to an annualimpairment review.  The Company maydetermine through the impairment review process that goodwill or otherindefinite-lived intangibles have been impaired, resulting in an impairmentcharge in the period the review is completed.

 

*Contingencies*

 

We are involved in certain legal proceedings.  Because of the uncertainties related to the amount of potentialloss, management is unable to make a reasonable estimate of the liability, ifany, that could result from an unfavorable outcome of these proceedings.  Accordingly, no amount has been accrued asof December 31, 2002 for these matters in the consolidated financialstatements.  The outcome of theseproceeding may have a material adverse effect on our consolidated financialposition.  It is possible that futureresults of operations for any particular quarterly or annual period could bematerially affected by changes in our assumptions, or the effectiveness of oursettlement or litigation strategies, related to these proceedings.

 

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**Resultsof Operations**

 

The following table setsforth certain statement of operations data as a percentage of total netrevenues for the periods indicated:

 

|                                                                         |   | **Year Ended  December 31,** |   |
|------------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                         |   | **2000**                     |   | **2001** |   | **2002** |   |
| **Statement  of Operations Data:**                                           |   |                         |   |   |   |   |   |
| Revenues:                                                                    |   |                         |   |   |   |   |   |
| Online  tuition revenues                                                     |   | 53.6                         | %      | 85.3 | % | 90.4 | % |
| Virtual  campus software revenues                                            |   | 1.2                          |   | 1.0 |   | 0.0 |   |
| Development  and other revenues                                              |   | 10.8                         |   | 9.9 |   | 8.0 |   |
| Product  sales revenues                                                      |   | 4.4                          |   | 0.6 |   | 0.0 |   |
| Other  service revenues                                                      |   | 1.8                          |   | 1.7 |   | 1.6 |   |
| Instructor-led  training revenues                                            |   | 28.2                         |   | 1.5 |   | 0.0 |   |
| Total  net revenues                                                          |   | 100.0                        |   | 100.0 |   | 100.0 |   |
| Costs  and expenses:                                                         |   |                         |   |   |   |   |   |
| Cost  of revenues                                                            |   | 34.9                         |   | 15.7 |   | 23.6 |   |
| Sales  and marketing                                                         |   | 66.1                         |   | 67.6 |   | 47.8 |   |
| Product  development and operations                                          |   | 37.6                         |   | 32.6 |   | 40.9 |   |
| General  and administrative                                                  |   | 29.2                         |   | 29.3 |   | 27.3 |   |
| Depreciation  and amortization                                               |   | 30.8                         |   | 30.9 |   | 21.9 |   |
| Reorganization  and other non-recurring charges and stock based compensation |   | 34.6                         |   | 9.0 |   | 4.3 |   |
| Total  costs and expenses                                                    |   | 233.2                        |   | 185.1 |   | 165.8 |   |
| Loss  from operations                                                        |   | (133.2                       | )      | (85.1 | ) | (65.8 | ) |
| Other  income (expense):                                                     |   |                         |   |   |   |   |   |
| Other  income                                                                |   | —                       |   | — |   | 6.8 |   |
| Interest  income (expense)                                                   |   | 1.8                          |   | 0.1 |   | (3.5 | ) |
| Loss  on debt extinguishment                                                 |   | —                       |   | — |   | (8.1 | ) |
| Cumulative  effect of accounting changes                                     |   | (4.9                         | )      | — |   | — |   |
| Net  loss                                                                    |   | (136.3%                      | )      | (85.0% | ) | (70.6% | ) |

 

**2002 Compared to 2001**

 

*Summary*

 

The Company incurred anet loss attributable to common stockholders of $7,147,305 (or $4.79 per share)in 2002 as compared to a net loss attributable to common stockholders of$6,582,040 (or $5.23 per share) in 2001. Excluding certain non-recurring itemsin both years, the Company incurred a net loss attributable to commonstockholders of $6,955,305 (or $4.66 per share) in 2002 as compared to a netloss attributable to common stockholders of $6,394,278 (or $5.08 per share) in2001.  Non-recurring items for 2002amounted to $192,000 (or $0.13 per share) incurred in connection with theclosure of the Company’s training facility in Rockville, Maryland.  Non-recurring items for 2001 amounted to$187,762 (or $0.15 per share) incurred in connection with the termination ofthe employment agreement between the Company and its founder.

 

Total revenues in 2002were $6,201,674 as compared to $6,973,231 for 2001. The decrease in revenueswas primarily due to decreases in online tuition revenues and development andother revenues.  Online tuition revenuesdecreased primarily due to a decrease in revenues from customers within thetelecommunications industry. Development and other revenues decreased primarily due to a decrease incourse development orders.  Excludingthe non-recurring items described above, total costs and expenses were$10,087,036 in 2002 as compared to costs of $12,722,925 for 2001. The decreasewas due primarily to decreases in sales and marketing, general andadministrative and depreciation and amortization expenses, partially offset byan increase in the cost of online tuition revenues.

 

*Net Revenues*

 

Total net revenuesdecreased 11.1% from $6,973,231 in 2001 to $6,201,674 in 2002. Online tuitionrevenues decreased from $5,944,764 (85.3% of net revenues) in 2001 to$5,606,214 (90.4% of net revenues) in 2002. The decrease in online tuition revenues was primarily due to a decreasein revenues from customers primarily within the telecommunications and otherindustries (approximately $900,000 and $800,000, respectively).  This decrease was partially offset by anincrease in revenues due to increased course usage  by some of the Company’s older higher education and governmentcustomers (approximately $300,000 and $475,000,

 

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respectively) and theaddition of a new government customer (approximately $600,000).** **Online development and otherrevenues decreased from $687,232 (9.9% of net revenues) in 2001 to $495,425(8.0% of net revenues) in 2002. Development revenues were primarily related todeveloping online courseware for customers in both years.  The Company recognized no virtual campussoftware revenues, product sales revenues, or instructor-led training revenuesin 2002 and only $100,000 in other service revenues due to the Company’scontinued move to an exclusive online business focus.

 

*Cost of Revenues*

 

Total cost of revenuesincreased 33.7% from $1,093,285 (15.7% of net revenues) in 2001 to $1,461,663(23.6% of net revenues) in 2002. The increase was primarily due to the sale ofcourses with relatively high associated royalties under one of the Company’slarge customer contracts which expires in June 2003.

 

*Operating Expenses*

 

*Sales and Marketing. *Sales and marketing expenses decreased 37.1% from$4,716,729 (67.6% of net revenues) in 2001 to $2,964,664 (47.8% of netrevenues) in 2002.   Although the Company increasedits sales headcount during the third quarter of 2002, compared to headcount inthat area earlier in 2002, sales and marketing expenses for 2002, nonetheless,decreased as compared to 2001 primarily due a comparatively lower headcountthroughout the year and lower direct marketing costs.  During 2002 and 2001, the Company contributed  $551,056 and $326,959, respectively, to amarketing and development fund (the “Development Fund”) jointly administered bythe Company and one of its larger customers as required pursuant to the termsof the Company’s contract with that customer. The Development Fund’s primary goal is to fund marketing and developmentto grow online revenues for both that customer and derivatively for the Companyin the form of course registration fees.  Amounts required to be contributed by the Company to theDevelopment Fund are determined under the contract based on meeting orexceeding certain thresholds in course registrations on that customer’s virtualcampus, which amounts are expensed as marketing costs in the same period as theCompany recognizes revenue from such registrations.  Contributions to the Development Fund represented 28.7% and 25.2%of the recognized revenues attributable to that customer for 2002 and 2001,respectively.

 

*Product Development and Operations. *Product development andoperations expenses increased 11.6% from $2,273,145 (32.6% of net revenues) in2001 to $2,535,849 (40.9% of net revenues) in 2002. Product development andoperations expenses consist primarily of certain costs associated with thedesign, programming, testing, documenting and support of the Company’s new andexisting courseware and software.  Theincrease was primarily due to the write off of $276,535 (which has been includedin product development costs in the 2002 statements of operations) incapitalized software and courseware development costs for courses within thetelecommunications industry segment determined to have no future value.

 

*General and Administrative. *General and administrative expenses decreased 17.2%from $2,044,716 (29.3% of net revenues) in 2001 to $1,692,851 (27.3% of netrevenues) in 2002. General and administrative expenses consist primarily ofpersonnel costs, facilities and related costs, as well as legal, accounting andother costs.  The decrease was due to the Company’s costcutting initiatives primarily in headcount and associated overhead.

 

*Depreciation and Amortization.*  Depreciation and amortization expensedecreased 37.1% from $2,154,152 (30.9% of net revenues) in 2001 to $1,355,837(21.9% of net revenues) in 2002.  The decrease was due primarily to the fact thatcertain of the Company’s fixed, as well as intangible, assets have been fullydepreciated and amortized, respectively. In addition, upon the adoption of FAS 142 on January 1, 2002, theCompany ceased amortization of goodwill. The Company recognized $128,447 of amortization expense related togoodwill in 2001.

 

*Reorganization and OtherNon-Recurring Charges*.  Reorganization and other non-recurring charges were $192,000 in 2002 andrepresent the minimum amount due under a lease for office space the Company isno longer using.   In December 2001, theemployment agreement between the Company and Mr. Kannan was terminated and Mr.Kannan became a consultant, resulting in $187,762 of severance related expense,most of which was paid out in 2002. During 2002, Mr. Kannan subsequently reassumed his employment with theCompany.

 

*Stock Based Compensation. *Stock-based compensation expense was $76,172 in 2002 and consistsprimarily of the fair value of stock issued as a sign-on bonus to the Company’snewly appointed CFO and as customary payment to certain of the Company’snon-employee directors for their participation in Board of Directors meetings. *  *Stock based compensation was $440,898 in2001 and included the final vesting of warrants issued to QwestInvestment Company (approximately $166,000) related to their equity investmentin VCampus in the second quarter of 2000 and compensatory stock options andstock warrants issued in connection with the issuance of debt to two VCampusdirectors and the subsequent extinguishment of that debt.  The fair value of the warrants and

22

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options was estimated at$212,750 and $47,150, respectively, using the Black-Scholes option pricingmodel and has been included in stock-based compensation in the consolidatedstatements of operations.

 

*Other income. *Other income was $421,842 in 2002 andconsists of the extinguishment of liabilities comprised of customer depositsand prepayments.  These prepayments anddeposits were received prior to December 31, 2000 and were for classroomtraining to be delivered by HTR and per the terms of the arrangement withcustomers, they were non refundable. The Company’s HTR subsidiary ceased operations in December 2000.

 

*Interest expense.*  Interestexpense in 2002 consists primarily of debt discount and deferred debt offeringcosts amortization related to remaining balance of the $825,000 and $100,000convertible promissory notes issued in December 2001 and January 2002,respectively.  Interest income in 2001was primarily derived from income earned on divestiture related notesreceivable.

 

*Loss on debt extinguishment.*  During 2002, the Company issued 1,458,413and 5,878 shares of  Series F-1 and F-2Preferred Stock, respectively, plus five-yearfully vested warrants to purchase 20,462 shares of common stock at $4.00 pershare in exchange for the cancellation of two convertible promissorynotes in the aggregate principal and accrued interest amount of  $716,175. The excess of the fair value of thePreferred Stock and warrants over the carrying value of the notes plus thewrite-off of deferred debt issuance costs amounted to $503,246 and was recordedas loss on debt extinguishments in 2002.

 

**2001 Compared to 2000**

 

*Summary*

 

The Company incurred anet loss attributable to common stockholders of $6,582,040 (or $5.23 per share)in 2001 as compared to a net loss attributable to common stockholders of$14,037,564 (or $17.65 per share) in 2000. Excluding certain non-recurringitems in both years, the Company incurred a net loss attributable to commonstockholders of $6,394,278 (or $5.08 per share) in 2001 as compared to a netloss attributable to common stockholders of $11,315,229 (or $14.23 per share)in 2000.  Non-recurring items for 2001amounted to $187,762 (or $0.15 per share) incurred in connection with thetermination of the employment agreement between the Company and its founder.  Non-recurring items for 2000 amounted to$2,722,335 (or $3.42 per share) and included $1,226,335 of adjustment togoodwill related to the Company’s restructuring of HTR, $700,000 of adjustmentto the Company’s note receivable related to the sale of Knowledgeworks,$335,000 of costs related to the Company’s restructuring of operations inDecember 2000, and $461,000 recorded in connection with the cumulative effectof change in accounting principle.

 

Total revenues in2001were $6,973,231 as compared to $9,456,083 for 2000. The decrease inrevenues was primarily due to the exit from the classroom-based trainingbusiness, culminating in the closing of the two remaining HTR trainingfacilities in December 2000. The decrease was partially offset by increases inonline tuition revenues. Online tuition revenues increased from $5,064,889 in2000 to $5,944,764 in 2001, primarily due to increased course usage by some ofthe Company’s older customers and the addition of new customers.  Excluding the non-recurring items describedabove, total costs and expenses were $12,282,027 in 2001 as compared to costsof $18,768,608 for 2000. The decrease was due primarily to decreases in productdevelopment and operations and sales and marketing expenses, and cost ofrevenues as the Company’s lower margin instructor-led training revenuesdecreased.

 

*Net Revenues*

 

Total net revenuesdecreased 26.3% from $9,456,083 in 2000 to $6,973,231 in 2001. Online tuitionrevenues increased from $5,064,889 (53.6% of net revenues) in 2000 to$5,944,764 (85.3% of net revenues) in 2001. The increase in online tuition revenues was primarily due to increasedcourse usage by some of the Company’s older customers (approximately $503,000)and the addition of new customers (approximately $376,000).** **Online development and other revenues decreased from $1,021,811(10.8% of net revenues) in 2000 to $687,232 (9.9% of net revenues) in 2001.Development revenues were primarily related to developing online courseware forcustomers in both years.  The decreasewas primarily due to a decline in the number of courses developed for one ofthe Company’s larger customers.  Productsales revenues decreased from $413,999 (4.4% of net revenues) in 2000 to$45,038 (0.6% of net revenues) in 2001. The decrease in product sales revenues was primarily due to thetransition of some Teletutor customers from CD-ROM to online usage.  Other service revenues decreased from$175,399 (1.9% of net revenues) in 2000 to $121,750 (1.7% of net revenues) in2001.  Both virtual campus softwarerevenues and other service revenues decreased due to the change in businessfocus of the Company. The Company anticipates that these revenues will continueto represent only a small portion of Company total revenues in the foreseeablefuture. Instructor-led training revenues decreased from $2,664,892 (28.2% ofnet revenues) in 2000 to $102,584 (1.5% of net revenues) in 2001.  This decrease was due primarily to theclosing of the remaining two HTR training facilities in December 2000.

 

23

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*Cost of Revenues*

 

Total cost of revenuesdecreased 66.8% from $3,296,284 (34.9% of net revenues) in 2000 to $1,093,285(15.7% of net revenues) in 2001. The decrease was due primarily to the closingof the remaining two lower margin instructor-led training facilities inDecember 2000 (representing a decrease of approximately $2,075,000) and thedecrease in online development and other revenues (representing a decrease ofapproximately $241,000) partially offset by the increase in cost of onlinerevenues (approximately $240,000) as a result of the increase in online tuitionrevenues.

 

*Operating Expenses*

 

*Sales and Marketing. *Sales and marketing expenses decreased 24.4% from$6,241,397 (66.1% of net revenues) in 2000 to $4,716,729 (67.6% of netrevenues) in 2001. Sales and marketing expenses consist primarily of costs relatedto personnel, sales commissions, travel, market research, advertising andmarketing materials.  The decrease wasdue primarily to the Company’s cost control measures implemented in the fourthquarter of 2000 as a result of management reorganization plans.  During 2001 and 2000, the Company contributed  $326,959 and $274,325, respectively, to amarketing and Development Fund jointly administered by the Company and one ofits larger customers as required pursuant to the terms of the Company’scontract with that customer.  TheDevelopment Fund’s primary goal is to fund marketing and development to growonline revenues for both that customer and derivatively for the Company in theform of course registration fees. Amounts required to be contributed by the Company to the DevelopmentFund are determined under the contract based on meeting or exceeding certainthresholds in course registrations on that customer’s virtual campus whichamounts, are expensed as marketing costs in the same period as the Company recognizesrevenue from such registrations. Contributions to the Development Fund represented 25.2% and 30.2% of therecognized revenues attributable to that customer for 2001 and 2000,respectively.

 

*Product Development and Operations. *Product development andoperations expenses decreased 36.1% to from $3,555,093 (37.6% of net revenues)in 2000 to $2,273,145 (32.6% of net revenues) in 2001. Product development andoperations expenses consist primarily of certain costs associated with thedesign, programming, testing, documenting and support of the Company’s new andexisting courseware and software.  Thedecrease was primarily due to cost control measures implemented beginning inthe fourth quarter of 2000 as a result of management reorganization plans.

 

* General andAdministrative. *Generaland administrative expenses decreased 25.9% from $2,759,682 (29.2% of netrevenues) in 2000 to $2,044,716 (29.3% of net revenues) in 2001. General andadministrative expenses consist primarily of personnel costs, facilities andrelated costs, as well as legal, accounting and other costs. The decrease wasprimarily due to cost control measures.

 

*Depreciation and Amortization.*  Depreciation and amortization expensedecreased 26.1% from $2,916,152 (30.8% of net revenues) in 2000 to $2,154,152(30.9% of net revenues) in 2001. Thedecrease was due primarily to the write-off of $1.2 million in goodwill inDecember 2000 related to the acquisition of HTR.

 

*Compensation expense in connection with the acquisition ofHTR, Inc.*During 2000, the Company recognized the finalportion of compensation expense of $654,294 related to compensation paid to theHTR executives pursuant to their employment agreements.

 

*Reorganization and Other Non-Recurring Charges.*  In December 2001, the employment agreementbetween the Company and Nat Kannan was terminated, resulting in $187,762 ofseverance related expense.  In December2000, the Company implemented a reorganization plan to reduce its workforce andclose certain office facilities.  Theplan called for and resulted in (i) the termination of approximately 37employees primarily from the product development and instructor-led trainingareas and (ii) the closure of the Company’s training facilities located inWashington, DC and Rockville, MD. As a result, the Company recorded arestructuring charge of approximately $1,561,000. The restructuring chargeincluded approximately $1,226,000 for the write off of goodwill related to HTRand $335,000 primarily for expenses related to facilities lease cancellations.  The operating activities of the closedfacilities were not tracked separately by the Company.  Reorganization and other non-recurringcharges in 2000 also included an increase of $700,000 to the Company’s reservefor its notes receivable issued in connection with the sale of Knowledgeworks,which note was restructured in 2000.

 

*Stock Based Compensation. *Stock based compensation was $440,898 in 2001 and included the final vesting of warrants issued to QwestInvestment Company (approximately $166,000) related to their equity investmentin VCampus in the second quarter of 2000 and compensatory stock options andstock warrants issued in connection with the issuance of debt to two VCampusdirectors and the subsequent extinguishment of that debt.  The fair value of the warrants andoptions was estimated at $212,750 and $47,150, respectively, using theBlack-Scholes option pricing model and has been included in stock-basedcompensation in the consolidated statements of operations.  Stock-based compensation was $361,391 in2000 and consisted of expense related to the issuance of compensatory stock andstock options to the Company’s newly appointed President and Chief ExecutiveOfficer, and compensatory stock and stock warrants issued to several serviceproviders.

 

24

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*Interest and Other Income (Expense).*  Interest income in 2001 and 2000 wasprimarily derived from income earned on divestiture-related notes receivableand cash raised in the Company’s private placements.  The decline in interest income during 2001 was primarily relatedto the smaller amount of financing raised in 2001, as compared to 2000.

 

**Liquidity and Capital Resources**

 

AtDecember 31, 2002, the Company had $727,466 in cash and cash equivalents. Sinceits inception, the Company has financed its operating cash flow needs primarilythrough offerings of equity and debt securities and, to a lesser extent,borrowings. Cash utilized in operating activities was $2,661,629 for the yearended December 31, 2002 and $3,253,893 for the year ended December 31, 2001.Use of cash was primarily attributable to the net loss recorded.

 

Cashutilized in investing activities was $422,438 for the year ended December 31,2002 as compared to $441,053 for the year ended December 31, 2001.  The useof cash for investing activities in 2002 and 2001 was primarily attributable topurchases of equipment and investments in software and courseware development.

 

Cashprovided by financing activities was $1,783,762 for the year ended December 31,2002 as compared to $5,479,513 provided by financing activities for the yearended December 31, 2001.  .

 

InMarch 2002, the Company issued 1,458,413 shares of Series F-1 Preferred Stockand five-year fully vested warrants to purchase 14,584 shares of common stockat $4.00 per share in exchange for the cancellation of a note in the originalprincipal amount of $500,000 plus $10,445 in accrued interest.  Each share of Series F-1 Preferred Stock was initially convertible into 1/10thof a share of common stock at any time at the election of the holder.

 

In May and June 2002, theCompany completed the following equity financing transactions:

 

1.               The sale of 242,859shares of Series F Preferred Stock for $85,000 in cash at $0.35 per share andwarrants to purchase 6,071 shares of common stock at $4.00 per share.  Each share of Series F Preferred Stock was initially convertible into 1/10thof a share of common stock at any time at the election of the holder.

 

2.               The sale of 17,859shares of Series F-2 Preferred Stock for approximately $625,000 in cash at$35.00 per share, each of which Series F-2 Preferred Share was initiallyconvertible into 10 shares of common stock, and warrants to purchase a total of160,365 shares of common stock at $4.00 per share.

 

3.               The issuance of5,878 shares of Series F-2 Preferred Stock plus a warrant to purchase 5,878shares of common stock at $4.00 per share, in exchange for the cancellation ofa convertible promissory note in the principal and accrued interest amount of$205,730, each of which Series F-2 Preferred Share was initially convertibleinto 10 shares of common stock.

 

4.               The issuance of3,841 shares of Series F-2 Preferred Stock in exchange for the cancellation of$126,970 of accounts payable, each of which Series F-2 Preferred Share wasinitially convertible into 10 shares of common stock.

 

5.               The sale of 114,305shares of Series F Preferred Stock for $40,007 in cash at $0.35 per share andwarrants to purchase 2,858 shares of common stock at $4.00 per share.  Each share of Series F Preferred Stock was initially convertible into 1/10thof a share of common stock at any time at the election of the holder.

 

Theconversion price applicable to the Series F, F-1 and F-2 Preferred Stockadjusted automatically from $3.50 to $2.196 as a result of antidilution rightstriggered by the Series G financing in September 2002.

 

InSeptember 2002, the Company raised approximately $1,000,000 through theissuance of 46,400 shares of Series G Preferred Stock at a purchase price of$21.96 per share (10 times the trailing five-day average closing priceof its common stock) to accredited investors. Under the terms of this financing, the Company also issued five-year fully vested warrants to purchase116,000 shares of common stock at $2.42 per share.  Each share of Series GPreferred Stock is convertible into 10 shares of common stock at any time atthe election of the holder.

 

In November 2002, the Company raised approximately$70,000 though the issuance of 2,800and 120 shares of Series G Preferred Stock at a purchase price of $24.90 pershare (10 times the trailing five-day average closing price of itscommon stock) to accredited investors and a placement agent, respectively.  Under the terms of this financing, theCompany also issued five-year fully vestedwarrants to purchase 7,000 and 300 shares of common stock at $2.74 per share tothe same accredited investors and placement agent,

 

25

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respectively.  Each share of Series G Preferred Stock is initially convertible into 10 shares ofcommon stock at any time at the election of the holder.

 

The Company expectsnegative cash flow from operations to continue until the online revenue streammatures. The Company believes it has access to adequate resources to fundoperations until operations reach cash flow positive.  However, in the event revenues do not meet anticipated levels orthe Company is unable to raise additional funding to meet working capitalrequirements, the Company may need to further reduce operating expenses. If theCompany is unable to raise additional funding to meet working capitalrequirements, it may be unable to maintain compliance with Nasdaq Small Capmarket listing requirements.  TheCompany believes it has available sources for debt or equity capital in amountsnecessary to, in addition to operating sources, meet its cash needs through2003.  However, such capital, ifavailable, may not have terms favorable to the Company or its currentstockholders.

 

Ifthe Company does not address its funding needs, it will be materially adverselyaffected. The Company’s future capital requirements will depend on manyfactors, including, but not limited to, acceptance of and demand for itsproducts and services, customer demands for technology upgrades, the types ofarrangements that the Company may enter into with customers and resellers, andthe extent to which the Company invests in new technology and research anddevelopment projects.

 

Asof December 31, 2002, the Company had net operating loss carryforwards ofapproximately $56 million for federal income tax purposes, which will expire atvarious dates through 2022. The Company’s ability to utilize all of its netoperating loss and credit carryforwards may be limited by changes inownership.  The Company has recognized afull valuation allowance against these deferred tax assets because it is morelikely than not that sufficient taxable income will not be generated during thecarryforward period available under the tax law to utilize the deferred taxassets.

 

*ContractualObligations*

 

The Company’s futureliquidity and capital resources will be affected by its contractualobligations.  The Company’s significantcontractual obligations as of December 31, 2002 are for debt, operating andcapital leases and purchase obligations. These obligations are summarized as follows:

 
|                           |   | **Payments  Due by Period** |      |
|--------------------------------|--------|-----------------------------|-----------|
| **Contractual  Obligations**   |   | **Total**                   |      | **Less than  one  year** |   | **1-3 years** |   | **4-5 years** |   | **After 5  years** |   |
|                           |   |                        |      |   |   |   |   |   |   |   |   |
| Notes  payable(1)              |   | $                           | 225,000   |   | $ | 225,000 |   | $ | — |   | $ | — |   | $ | — |   |
| Operating  leases              |   | 4,052,238                   |      | 656,096 |   | 1,034,762 |   | 1,097,779 |   | 1,263,601 |   |
| Capital  lease obligations     |   | 23,529                      |      | 23,529 |   | — |   | — |   | — |   |
| Purchase  obligation(2)        |   | 362,303                     |      | 362,303 |   | — |   | — |   | — |   |
|                           |   |                        |      |   |   |   |   |   |   |   |   |
| Total  contractual obligations |   | $                           | 4,663,070 |   | $ | 1,266,928 |   | $ | 1,034,762 |   | $ | 1,097,779 |   | $ | 1,263,601 |   |

 

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(1)  In December 2001 and January 2002, theCompany raised $825,000 and $100,000 through the issuance of 8% debenturestogether with five-year, fully vested warrants to purchase 132,143 shares ofcommon stock at $4.00 per share.  TheCompany allocated the proceeds of the offering to the debentures and thewarrants based on their relative fair values. The amount allocated to the warrants was recorded as a debt discount andis being amortized to interest expense over the period the debentures areexpected to be outstanding.     InMarch 2002, the Company issued 1,458,413 shares of Series F-1 Preferred Stockand five-year fully vested warrants to purchase 14,584 shares of common stockat $4.00 per share in exchange for the cancellation of a note in the originalprincipal amount of $500,000 plus $10,445 in accrued interest.  In May 2002, the Company issued of5,878 shares of Series F-2 Preferred Stock plus a warrant to purchase 5,878shares of common stock at $4.00 per share, in exchange for the cancellation ofa convertible promissory note in the principal and accrued interest amount of$205,730.  The unamortized debt discountat December 31, 2002 was $84,841.  Theremaining $225,000 of principal and accrued interest under the debentures aredue and payable at December 31, 2003.

 

(2)  In December 2000, the Company entered into athree-year reseller agreement with a vendor to resell certain software.  The agreement, as amended, requires theCompany to generate sales of the vendor’s software of $650,000 over the three-yearperiod.  As of December 31, 2002, theCompany was required to generate sales sufficient to generate royalties of$362,303 prior to December 31, 2003.

 

The Company has notengaged in off-balance sheet financing or commodity contract trading.

 

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**Item 7A.* *Quantitative andQualitative Disclosures About Market Risk.**

 

Notapplicable.

 

**Item 8.  Financial Statements andSupplementary Data.**

 

The information requiredby this item is included in this Report at pages F-1 through F-25  See Index to Consolidated FinancialStatements on page F-1.

 

**Item 9.  Changes In andDisagreements With Accountants on Accounting and Financial Disclosure.**

 

Notapplicable.

 

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**PART III**

 

Certaininformation required by Part III is omitted from this report because theRegistrant intends to file a definitive proxy statement for its 2003 AnnualMeeting of Stockholders (the “Proxy Statement”) within 120 days after the endof its fiscal year pursuant to Regulation 14A promulgated under the SecuritiesExchange Act of 1934, as amended, and the information included therein isincorporated herein by reference to the extent provided below.

 

**Item 10. Directors and Executive Officers of the Registrant.**

 

Theinformation required by Item 10 of Form 10-K concerning the Registrant’sexecutive officers is set forth under the heading “Executive Officers” locatedat the end of Part I of this Report.

 

Theother information required by Item 10 of Form 10-K concerning the Registrant’sdirectors is incorporated by reference to the information under the heading“Proposal No. 1 — Election of Directors” and “Other Information — Section 16(a)Beneficial Ownership Reporting Compliance” in the Proxy Statement.

 

**Item 11. Executive Compensation.**

 

Theinformation required by Item 11 of Form 10-K is incorporated by reference tothe information under the heading “Proposal No. 1 — Election of Directors —Information Concerning the Board of Directors and Its Committees”, “OtherInformation — Executive Compensation”, “— Compensation of Directors”, “— Reportof the Compensation Committee on Executive Compensation”, “— CompensationCommittee Interlocks and Insider Participation” and “— Performance Graph” inthe Proxy Statement.

 

**Item 12. Security Ownership of CertainBeneficial Owners and Management.**

 

Theinformation required by Item 12 of Form 10-K is incorporated by reference tothe information under the heading “Other Information — Principal Stockholders”and “Other Information—Equity Compensation Plan Information” in the ProxyStatement.

 

**Item 13. Certain Relationships andRelated Transactions.**

 

Theinformation required by Item 13 of Form 10-K is incorporated by reference tothe information under the heading “Other Information — Certain Transactions” inthe Proxy Statement.

 

**Item14.  Controls and Procedures**

 

(a) Evaluation ofdisclosure controls and procedures.  Within90 days prior to the date of this report, the Company carried out anevaluation, under the supervision and with the participation of the Company’smanagement, including the Company’s Chief Executive Officer and Chief FinancialOfficer, of the effectiveness of the design and operation of the Company’sdisclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Basedupon that evaluation, the Company’s Chief Executive Officer and Chief FinancialOfficer have concluded that the Company’s disclosure controls and proceduresare effective.

 

(b) Changes ininternal controls.  There have beenno significant changes in the Company’s internal controls or, to the knowledgeof these officers, in other factors that could significantly affect thesecontrols subsequent to the date of their evaluation.

 

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**PARTIV**

 

**Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.**

 

(a)           The following Financial Statements,Financial Statement Schedules and Exhibits are filed as part of this report orincorporated herein by reference:

 

(1)           Financial Statements.

 

SeeIndex to Consolidated Financial Statements on page F-1.

 

(2)           Financial Statement Schedules.

 

Thefollowing financial statement schedule is filed with this report: Schedule II —Valuation and Qualifying Account and Reserve

 

Allother financial statement schedules for which provision is made in RegulationS-X are omitted because they are not required under the related instructions,are inapplicable, or the required information is given in the financialstatements, including the notes thereto and, therefore, have been omitted.

 

(3)          Exhibits.

 
| **Exhibit No.** |   | **Description**                                                                                                                                            |
|-----------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------|
|  3.1(a)    |   | Amended  and Restated Certificate of Incorporation, as currently in effect.                                                                                |
|  3.2(a)    |   | Amended  and Restated Bylaws, as currently in effect.                                                                                                      |
|  4.1(a)    |   | Form  of Common Stock certificate.                                                                                                                         |
| 10.30(b)        |   | Series  C Preferred Stock and Warrant Purchase Agreement.                                                                                                  |
| 10.32(b)        |   | Series  D Preferred Stock Purchase Agreement dated June 29, 1998.                                                                                          |
| 10.34(b)        |   | Certificate  of Designations, Preferences and Rights of Series D Convertible Preferred  Stock dated June 26, 1998.                                         |
| 10.35(c)        |   | Certificate  of Designations, Preferences and Rights of Series C Convertible Preferred  Stock dated June 25, 1998.                                         |
| 10.42(d)        |   | Certificate of Designations,  Preferences and Rights of Series E Convertible Preferred Stock.                                                              |
|            |   |                                                                                                                                                       |
| 10.47(e)        |   | Stock Purchase Agreement dated  as of January 11, 2000 by and among the Registrant and Mastech Corporation  (now iGate Capital Corporation).               |
| 10.48(e)        |   | Registration  Rights Agreement dated as of January 11, 2000 by and among the Registrant and  Mastech Corporation (now iGate Capital Corporation).          |
| 10.49(e)        |   | Warrant  issued to Mastech Corporation (now iGate Capital Corporation), dated as of  January 11, 2000.                                                     |
| 10.50(f)        |   | Subscription  Agreement dated as of April 20, 2000, by and between the Registrant and US  West Internet Ventures, Inc, now Qwest Investment Company        |
| 10.51(f)        |   | Registration  Rights Agreement dated as of April 20, 2000 by and between the Registrant and  US West Internet Ventures, Inc, now Qwest Investment Company. |
| 10.52(f)        |   | Warrant  issued to US West Internet Ventures, Inc., now Qwest Investment Company,  dated as of April 20, 2000.                                             |
| 10.54(g)*       |   | Application  Hosting Agreement dated April 20, 2000 between the Company and US West  Interprise America, Inc.                                              |
| 10.55  (h)      |   | Employment  Agreement, dated August 8, 2000, with Daniel J. Neal.                                                                                          |
| 10.56  (h)      |   | Amendment  No.1 to Employment Agreement with Narasimhan P. Kannan dated August 10, 2000.                                                                   |
| 10.57(i)*       |   | Contract  with the General Services Administration dated April 18, 2001                                                                                    |
| 10.58(j)        |   | Form  of Subscription Agreement dated as of May 29, 2001 by and between the  registrant and the Purchasers.                                                |
| 10.59(j)        |   | Form  of Registration Rights Agreement dated as of May 29, 2001 by and between the  registrant and the Purchasers.                                         |
| 10.60(j)        |   | Warrant  issued to the purchasers dated as of May 29, 2001.                                                                                                |
| 10.61(j)        |   | Warrant  issued to the placement agent for the May 29, 2001 private placement.                                                                             |
| 10.62(k)        |   | Termination  of Employment Agreement with Narasimhan P. Kannan, dated December 31, 2001                                                                    |
| 10.63(l)        |   | Certificate of  Designations for the Series F-1 Preferred Stock, as filed in Delaware on  March 28, 2002                                                   |

 

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| 10.64(l) |   | Certificate of  Designations for the Series F-2 Preferred Stock, as filed in Delaware on May  8, 2002                                             |
|----------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.65(l) |   | Form of purchase  agreement for the issuance of Series F, F-1 and F-2 preferred stock                                                             |
| 10.66(l) |   | Form of registration  rights agreement covering the Series F, F-1 and F-2 preferred stock                                                         |
| 10.67(l) |   | Form of warrant issued  in connection with the Series F, F-1 and F-2 preferred stock financings                                                   |
| 10.68(m) |   | Employment  Agreement, dated June 3, 2002, with Christopher L. Nelson                                                                             |
| 10.69(n) |   | Certificate of  Correction of Series C Convertible Preferred Stock filed in Delaware on July  2, 2002,                                            |
| 10.70(n) |   | Certificate of  Correction of Series D Convertible Preferred Stock filed in Delaware on July  2, 2002.                                            |
| 10.71(n) |   | Certificate of  Correction of Series E Convertible Preferred Stock filed in Delaware on July  2, 2002.                                            |
| 10.72(n) |   | Certificate of Correction  of Series F Convertible Preferred Stock filed in Delaware on July 2, 2002.                                             |
| 10.73(n) |   | Certificate of  Correction of Series F-1 Convertible Preferred Stock filed in Delaware on  July 2, 2002.                                          |
| 10.74(n) |   | Certificate of  Correction of Series F-2 Convertible Preferred Stock filed in Delaware on  July 10, 2002.                                         |
| 10.75(n) |   | Certificate of  Amendment of Amended and Restated Certificate of Incorporation filed in  Delaware on July 3, 2002.                                |
| 10.76(o) |   | Certificate of  Designations for the Series G Preferred Stock filed with the Delaware  Secretary of State on September 27, 2002.        |
| 10.77(o) |   | Form of Securities  Purchase Agreement dated September 30, 2002 between the Registrant and  the purchasers of Series G Preferred Stock. |
| 10.78(o) |   | Form of Registration Rights Agreement dated  September 30, 2002 between the Registrant and the purchasers of  Series G Preferred Stock  |
| 10.79(o) |   | Form of Warrant issued  on September 30, 2002 to the purchasers of Series G Preferred  Stock.                                           |
| 10.80(p) |   | Amended and Restated  Employment Agreement, dated December 18, 2002, with Daniel J. Neal.                                                    |
| 10.81(p) |   | Employment Agreement,  effective January 1, 2003, with Narasimhan P. Kannan                                                                       |
| 21.1     |   | List of Subsidiaries                                                                                                                              |
| 23.1     |   | Consent of Ernst &  Young LLP, Independent Auditors                                                                                           |
| 99.1(q)  |   | Securities  Purchase Agreement dated December 28, 2001 between the Registrant and the  Purchasers                                                 |
| 99.2(q)  |   | Form  of Convertible Note issued December 28, 2001                                                                                                |
| 99.3(q)  |   | Certificate  of Designations for the Series F Preferred Stock filed in Delaware on  December 28, 2001                                             |
| 99.4(q)  |   | Form  of Warrant issued to the Series F holders on December 28, 2001                                                                              |
| 99.5(q)  |   | Form  of Warrant issued to the convertible noteholders on December 28, 2001                                                                       |
| 99.6(q)  |   | Form  of Registration Rights Agreement dated December 28, 2001                                                                                    |
| 99.7(j)  |   | Audit  Committee Charter                                                                                                                          |
| 99.8     |   | Chief  Executive Officer Certification pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002                                                 |
| 99.9     |   | Chief  Financial Officer Certification pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002                                                 |

 

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*Confidential treatment granted.

(a)                                           Incorporated by reference to the similarlynumbered Exhibit to the Registrant’s Registration Statement on Form S-1 (FileNo. 333-12135).

(b)                                          Incorporated by reference to the identicallynumbered Exhibit to the Registrant’s Quarterly Report on Form 10-Q for thequarter ended March 31, 1998.

(c)                                           Incorporated by reference to the identicallynumbered Exhibit to the Registrant’s Quarterly Report on Form 10-Q for thequarter ended June 30, 1998.

(d)                                          Incorporated by reference to the correspondingappendix filed with the Registrant’s preliminary proxy materials on Schedule14A dated July 16, 1999 for its 1999 annual meeting of stockholders.

(e)                                           Incorporated by reference to the similarlynumbered Exhibit to the Registrant’s current Report on Form 8-K filed January13, 2000.

(f)                                             Incorporated by reference to the similarlynumbered Exhibit to the Registrant’s current Report on Form 8-K filed May 1,2000.

 

30

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(g)                                 Incorporated by reference to the similarlynumbered Exhibit to the Registrant’s Quarterly Report on Form 10-Q filed May 15,2000.

(h)                                 Incorporated by reference to the similarlynumbered Exhibit to the Registrant’s Annual Report on Form 10-K for the yearended December 31, 2000.

(i)                                     Incorporated by reference to the similarlynumbered Exhibit to the Registrant’s Quarterly Report on Form 10-Q filed May15, 2001.

(j)                                     Incorporated by reference to the similarlynumbered Exhibit to the Registrant’s current Report on Form 8-K filed June 1,2001.

(k)                                  Incorporated by reference to the similarlynumbered Exhibit to the Registrant’s Annual Report on Form 10-K filed April 1,2002.

(l)                                     Incorporated by reference to the similarlynumbered Exhibit to the Registrant’s Quarterly Report on Form 10-Q filed May15, 2002.

(m)                               Incorporated by reference to the similarlynumbered Exhibit to the Registrant’s current report on Form 8-K filed June 28,2002.

(n)                                 Incorporated by reference to the similarlynumbered Exhibit to the Registrant’s Quarterly Report on Form 10-Q filed August9, 2002.

(o)                                 Incorporated by reference to the similarlynumbered Exhibit to the Registrant’s current report on Form 8-K filed October3, 2002.

(p)                                 Incorporated by reference to the similarlynumbered Exhibit to the Registrant’s current report on Form 8-K filed January24, 2003.

(q)                                 Incorporated by reference to the similarlynumbered Exhibit to the Registrant’s current report on Form 8-K filed January8, 2002

 

31

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**SIGNATURES**

 

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

 
|                  | VCAMPUS  CORPORATION |
|-----------------------|----------------------|
|                  |                 |
|                  | By:                  | /s/  Narasimhan P. Kannan |   |
|                  |                 | Narasimhan  P. Kannan, Chief Executive Officer |
| Date:  March 28, 2003 |                 |

 

Pursuant to the requirements ofthe Securities Exchange Act of 1934, this report has been signed below by thefollowing person on behalf of the Registrant and in the capacities and on thedates indicated.

 
| **Signature**                 |   | **Capacity**                    |            | **Date** |
|-------------------------------|--------|---------------------------------|-----------------|----------|
|                          |   |                            |
| /s/  NARASIMHAN P. KANNAN     |   | Chairman  and Chief             | March  28, 2003 |
| Narasimhan P. Kannan          |   | Executive  Officer              |            |
|                          |   | (Principal  Executive  Officer) |            |
|                          |   |                            |            |
| /s/  CHRISTOPHER L. NELSON    |   | Chief  Financial Officer        | March  28, 2003 |
| Christopher  L. Nelson        |   | (Principal  Financial and       |            |
|                          |   | Accounting  Officer)            |            |
|                          |   |                            |            |
|  /s/ EDSON D. DECASTRO   |   | Director                        | March  18, 2003 |
| Edson  D. deCastro            |   |                            |            |
|                          |   |                            |            |
|  /s/ WILLIAM E. KIMBERLY |   | Director                        | March  23, 2003 |
| William  E. Kimberly          |   |                            |            |
|                          |   |                            |            |
| /s/  MARTIN E. MALESKA        |   | Director                        | March  27, 2003 |
| Martin E. Maleska             |   |                            |            |
|                          |   |                            |            |
| /s/ DANIEL J. NEAL            |   | Director                        | March  28, 2003 |
| Daniel J. Neal                |   |                            |            |
|                          |   |                            |            |
| /s/  JOHN D. SEARS            |   | Director                        | March  24, 2003 |
| John  D. Sears                |   |                            |            |
|                          |   |                            |            |
| /s/  DENNIS J. FISCHER        |   | Director                        | March  18, 2003 |
| Dennis J. Fischer             |   |                            |            |
|                               |        |                                 |                 |          |  |

 

32

----

 

**CERTIFICATION**

 

*Securitiesand Exchange Act of 1934 Rule 13a-14 as adopted pursuant toSection 302 of Sarbanes-Oxley Act of 2002:*

 

I, Narasimhan P. Kannan,certify that:

 

1.               I have reviewedthis annual**report on Form**10K of VCampus Corporation;

 

2.               Based on myknowledge, this annual report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this annual****report;

 

3.               Based on my knowledge,the financial statements, and other financial information included in thisannual report, fairly present in all material respects the financial condition,results of operations and cash flows of the registrant as of, and for, theperiods presented in this annual report;

 

4.               The registrant’sother certifying officer and I are responsible for establishing and maintainingdisclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and15d-14) for the registrant and have:

 

a.               designed suchdisclosure controls and procedures to ensure that material information relatingto the registrant, including its consolidated subsidiaries, is made known to usby others within those entities, particularly during the period in which thisannual report is being prepared;

 

b.              evaluated theeffectiveness of the registrant’s disclosure controls and procedures as of adate within 90 days prior to the filing date of this annual report (the“Evaluation Date”); and

 

c.               presented in thisannual report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5.               The registrant’sother certifying officer and I have disclosed, based on our most recentevaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunctions):

 

a.               all significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrant’s ability to record, process, summarize andreport financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b.              any fraud, whetheror not material, that involves management or other employees who have asignificant role in the registrant’s internal controls; and

 

6.               The registrant’sother certifying officers and I have indicated in this annual report whetherthere were significant changes in internal controls or in other factors thatcould significantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 
|   | Date:  March  28, 2003 | By:                     | /s/ NARASIMHAN P. KANNAN |
|--------|-----------------------------|-------------------------|--------------------------|
|   |                        | Narasimhan P. Kannan    |
|   |                        | Chief Executive Officer |

 

33

----

 

**CERTIFICATION**

 

*Securitiesand Exchange Act of 1934 Rule 13a-14 as adopted pursuant toSection 302 of Sarbanes-Oxley Act of 2002:*

 

I, Christopher L. Nelson,certify that:

 

1.     I have reviewed this annual**reporton Form**10K of VCampusCorporation.;

 

2.               Based on myknowledge, this annual report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this annual****report;

 

3.               Based on myknowledge, the financial statements, and other financial information includedin this annual report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this annual report;

 

4.               The registrant’sother certifying officer and I are responsible for establishing and maintainingdisclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and15d-14) for the registrant and have:

 

a.               designed suchdisclosure controls and procedures to ensure that material information relatingto the registrant, including its consolidated subsidiaries, is made known to usby others within those entities, particularly during the period in which thisannual report is being prepared;

 

b.              evaluated theeffectiveness of the registrant’s disclosure controls and procedures as of adate within 90 days prior to the filing date of this annual report (the“Evaluation Date”); and

 

c.               presented in thisannual report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5.               The registrant’sother certifying officer and I have disclosed, based on our most recentevaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunctions):

 

a.                     all significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrant’s ability to record, process, summarize andreport financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b.                    any fraud,whether or not material, that involves management or other employees who have asignificant role in the registrant’s internal controls; and

 

6.               The registrant’sother certifying officer and I have indicated in this annual report whetherthere were significant changes in internal controls or in other factors thatcould significantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 
| Date:  March 28, 2003 | By:    | /s/ CHRISTOPHER L. NELSON |   |
|----------------------------|--------|---------------------------|--------|
|                       |   | Christopher L. Nelson     |   |
|                       |   | Chief Financial Officer   |   |

 

34

----

 

**VCAMPUS CORPORATION**

 

 

**INDEX TO CONSOLIDATED FINANCIALSTATEMENTS**

 

| Report of Ernst & Young LLP, Independent  Auditors                                                      | F-2 |
|-------------------------------------------------------------------------------------------------------------|-----|
| Consolidated Balance Sheets  as of December 31, 2001 and 2002                                               | F-3 |
| Consolidated  Statements of Operations for the Years Ended December 31, 2000, 2001 and 2002                 | F-4 |
| Consolidated  Statements of Stockholders’ Equity for the Years Ended December 31, 2000,  2001 and 2002 | F-5 |
| Consolidated  Statements of Cash Flows for the Years Ended December 31, 2000, 2001 and 2002                 | F-6 |
| Notes to  Consolidated Financial Statements                                                                 | F-7 |

 

F-1

----

 

**REPORT****OF ERNST& YOUNG LLP, INDEPENDENT AUDITORS**

 

Board of Directors

VCampus Corporation

 

We have audited the accompanying consolidated balancesheets of VCampus Corporation as of December 31, 2001 and 2002, and the relatedconsolidated statements of operations, stockholders’ equity, and cash flows foreach of the three years in the period ended December 31, 2002. Our audits alsoincluded the financial statement schedule listed in the Index at Item15(a).  These financial statements andschedule are the responsibility of the Company’s management. Our responsibilityis to express an opinion on these financial statements and schedule based onour audits.

 

We conducted our audits in accordance with auditingstandards generally accepted in the United States. Those standards require thatwe plan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of VCampus Corporation at December 31, 2001 and 2002, and theconsolidated results of its operations and its cash flows for each of the threeyears in the period ended December 31, 2002, in conformity with accountingprinciples generally accepted in the United States.  Also, in our opinion, the related financial statement schedule,when considered in relation to the basic financial statements taken as a whole,presents fairly in all material respects the information set forth therein.

 

As discussed in Note 2 and Note 6 to the consolidatedfinancial statements, effective January 1, 2002, VCampus Corporation adoptedStatement of Financial Accounting Standards No. 142, “Accounting for Goodwilland Other Intangible Assets.” As discussed in Note 2, effective April 1, 2002,VCampus Corporation adopted Statement of Financial Accounting Standards, No.145 “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASBStatement No. 13 and Technical Corrections.”

 
|                                                                        | /s/ ERNST &  YOUNG LLP |
|-----------------------------------------------------------------------------|----------------------------|
|                                                                        |
| McLean, Virginia                                                            |
| March 14, 2003, except  for Note 17, as to which the date is March 28, 2003 |

 

F-2

----

 

**VCAMPUS CORPORATION**

 

**CONSOLIDATED BALANCE SHEETS**

** **
|                                                                                                                                                                                                                                                                                                                |   | **December  31  2001** |       | **December  31  2002** |       |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------|------------|------------------------|------------|
| ASSETS                                                                                                                                                                                                                                                                                                              |   |                   | ** ** |                   | ** ** |
|                                                                                                                                                                                                                                                                                                                |   |                   | ** ** |                   | ** ** |
| Current  assets:                                                                                                                                                                                                                                                                                                    |   |                   |       |                   |       |
| Cash  and cash equivalents                                                                                                                                                                                                                                                                                          |   | $                      | 2,027,771  |                   | $          | 727,466 |   |
| Accounts  receivable, less allowance of $99,000 and $31,000 at December 31, 2001  and  2002, respectively                                                                                                                                                                                                      |   | 668,180                |       | 354,340                |       |
| Loans  receivable from related party                                                                                                                                                                                                                                                                                |   | 140,183                |       | 116,753                |       |
| Loans  receivable – current                                                                                                                                                                                                                                                                                    |   | 159,736                |       | 38,689                 |       |
| Prepaid  expenses and other current assets                                                                                                                                                                                                                                                                          |   | 287,393                |       | 659,587                |       |
| Total  current assets                                                                                                                                                                                                                                                                                               |   | 3,283,263              |       | 1,896,835              |       |
| Property  and equipment, net                                                                                                                                                                                                                                                                                        |   | 944,795                |       | 328,296                |       |
| Capitalized  software costs and courseware development costs, net                                                                                                                                                                                                                                                   |   | 1,146,230              |       | 814,730                |       |
| Acquired  online publishing rights, net                                                                                                                                                                                                                                                                             |   | 6,230                  |       | —                 |       |
| Loans  receivable — less current portion                                                                                                                                                                                                                                                                       |   | 95,441                 |       | 65,502                 |       |
| Other  assets                                                                                                                                                                                                                                                                                                       |   | 242,886                |       | 190,446                |       |
| Other  intangible assets, net                                                                                                                                                                                                                                                                                       |   | 964,347                |       | 748,492                |       |
| Goodwill,  net                                                                                                                                                                                                                                                                                                      |   | 328,317                |       | 328,317                |       |
| Total  assets                                                                                                                                                                                                                                                                                                       |   | $                      | 7,011,509  |                   | $          | 4,372,618 |   |
|                                                                                                                                                                                                                                                                                                                |   |                   |       |                   |       |
| LIABILITIES  AND STOCKHOLDERS’ EQUITY                                                                                                                                                                                                                                                                          |   |                   |       |                   |       |
| Current  liabilities:                                                                                                                                                                                                                                                                                               |   |                   |       |                   |       |
| Accounts  payable                                                                                                                                                                                                                                                                                                   |   | $                      | 1,261,799  |                   | $          | 950,262 |   |
| Accrued  expenses                                                                                                                                                                                                                                                                                                   |   | 1,203,103              |       | 827,860                |       |
| Capital  lease obligation — current portion                                                                                                                                                                                                                                                                    |   | 206,924                |       | 23,529                 |       |
| Notes  payable — current portion                                                                                                                                                                                                                                                                               |   | 492,351                |       | 140,159                |       |
| Deferred  revenues                                                                                                                                                                                                                                                                                                  |   | 1,003,892              |       | 783,003                |       |
| Total  current liabilities                                                                                                                                                                                                                                                                                          |   | 4,168,069              |       | 2,724,813              |       |
|                                                                                                                                                                                                                                                                                                                |   |                   |       |                   |       |
| Long-term  liabilities:                                                                                                                                                                                                                                                                                             |   |                   |       |                   |       |
| Capital  lease obligation — less current portion                                                                                                                                                                                                                                                               |   | 29,707                 |       | —                 |       |
| Total  liabilities                                                                                                                                                                                                                                                                                                  |   | 4,197,776              |       | 2,724,813              |       |
|                                                                                                                                                                                                                                                                                                                |   |                   |       |                   |       |
| Stockholders’  equity:                                                                                                                                                                                                                                                                                         |   |                   |       |                   |       |
| Series  C convertible Preferred Stock, $0.01 par value per share; aggregate  liquidation preference of $7,910,172 at December 31, 2001 and 2002; 1,000,000  shares authorized; 623,339 shares issued and outstanding at December 31, 2001  and 2002                                                                 |   | 6,233                  |       | 6,233                  |       |
| Series  D convertible Preferred Stock, $0.01 par value per share; aggregate  liquidation preference of  $8,363,924  at December 31, 2001 and 2002; 1,200,000 shares authorized; 1,013,809 shares  issued and outstanding at December 31, 2001 and 2002                                                         |   | 10,138                 |       | 10,138                 |       |
| Series  E convertible Preferred Stock, $0.01 par value per share; aggregate  liquidation preference of $1,940,467 and $1,816,668 at December 31, 2001 and  2002, respectively;  3,000,000 shares  authorized; 545,075 and 574,895 shares issued and outstanding at December 31,  2001 and 2002, respectively   |   | 5,451                  |       | 5,749                  |       |
| Series  F convertible Preferred Stock, $0.01 par value per share; aggregate  liquidation preference of $924,993 and $1,050,000 at December 31, 2001 and  2002, respectively; 3,000,000 shares authorized; 2,642,836 and 3,000,000  shares issued and outstanding at December   31, 2001 and 2002, respectively |   | 26,428                 |       | 30,000                 |       |
| Series  F-1 convertible Preferred Stock, $0.01 par value per share; aggregate  liquidation preference of $0 and $510,445 at December 31, 2001 and 2002,  respectively; 1,458,413 shares authorized; 0 and 1,458,413 shares issued and  outstanding at December  31, 2001 and,  2002, respectively              |   | —                 |       | 14,584                 |       |
| Series  F-2 convertible Preferred Stock, $0.01 par value per share; aggregate  liquidation preference of $0 and $965,230 at December 31, 2001 and 2002,  respectively; 60,000 shares authorized; 0 and 27,578 shares issued and  outstanding at December 31, 2001 and 2002,   respectively                     |   | —                 |       | 276                    |       |
| Series  G convertible Preferred Stock, $0.01 par value per share; aggregate  liquidation preference of $0 and $1,091,652 at December 31, 2001 and December  31, 2002, respectively; 80,000 shares authorized; 0, and 49,320 shares issued  and outstanding at December 31, 2001 and 2002, respectively              |   | —                 |       | 492                    |       |
| Common  Stock, $0.01 par value per share; 36,000,000 shares authorized; 1,469,868 and  1,573,904 shares issued and outstanding at December 31, 2001 and 2002,  respectively                                                                                                                                         |   | 14,699                 |       | 15,739                 |       |
| Additional  paid-in capital                                                                                                                                                                                                                                                                                         |   | 79,910,507             |       | 85,771,622             |       |
| Series  F convertible Preferred Stock subscribed                                                                                                                                                                                                                                                                    |   | (100,000               | )          | —                 |       |
| Accumulated  deficit                                                                                                                                                                                                                                                                                                |   | (77,059,723            | )          | (84,207,028            | )          |
| Total  stockholders’ equity                                                                                                                                                                                                                                                                                    |   | 2,813,733              |       | 1,647,805              |       |
| Total  liabilities and stockholders’ equity                                                                                                                                                                                                                                                                    |   | $                      | 7,011,509  |                   | $          | 4,372,618 |   |

 

The accompanyingnotes are an integral part of the financial statements.

 

F-3

----

 

**VCAMPUS CORPORATION**

 

**CONSOLIDATED STATEMENTS OF OPERATIONS**

** **
|                                                                           |   | **Years  ended December 31,** |        |
|--------------------------------------------------------------------------------|--------|-------------------------------|-------------|
|                                                                           |   | **2000**                      |        | **2001** |   | **2002** |   |
| Revenues:                                                                      |   |                          |        |   |   |   |   |
| Online  tuition revenues                                                       |   | $                             | 5,064,889   |   | $ | 5,944,764 |   | $ | 5,606,214 |   |
| Virtual  campus software revenues                                              |   | 115,093                       |        | 71,863 |   | — |   |
| Online  development and other revenues                                         |   | 1,021,811                     |        | 687,232 |   | 495,425 |   |
| Product  sales revenues                                                        |   | 413,999                       |        | 45,038 |   | — |   |
| Other  service revenues                                                        |   | 175,399                       |        | 121,750 |   | 100,035 |   |
| Instructor-led  training revenues                                              |   | 2,664,892                     |        | 102,584 |   | — |   |
| Net  revenues                                                                  |   | 9,456,083                     |        | 6,973,231 |   | 6,201,674 |   |
| Costs  and expenses:                                                           |   |                          |        |   |   |   |   |
| Cost  of revenues                                                              |   | 3,296,284                     |        | 1,093,285 |   | 1,461,663 |   |
| Sales  and marketing                                                           |   | 6,241,397                     |        | 4,716,729 |   | 2,964,664 |   |
| Product  development and operations                                            |   | 3,555,093                     |        | 2,273,145 |   | 2,535,849 |   |
| General  and administrative                                                    |   | 2,759,682                     |        | 2,044,716 |   | 1,692,851 |   |
| Depreciation  and amortization                                                 |   | 2,916,152                     |        | 2,154,152 |   | 1,355,837 |   |
| Compensation  expense in connection with the acquisition of HTR, Inc           |   | 654,294                       |        | — |   | — |   |
| Reorganization  and other non-recurring charges                                |   | 2,261,335                     |        | 187,762 |   | 192,000 |   |
| Stock-based  compensation                                                      |   | 361,391                       |        | 440,898 |   | 76,172 |   |
| Total  costs and expenses                                                      |   | 22,045,628                    |        | 12,910,687 |   | 10,279,036 |   |
|                                                                           |   |                          |        |   |   |   |   |
| Loss  from operations                                                          |   | (12,589,545                   | )           | (5,937,456 | ) | (4,077,362 | ) |
|                                                                           |   |                          |        |   |   |   |   |
| Other  income                                                                  |   | —                        |        | — |   | 421,842 |   |
| Interest  (expense) income                                                     |   | 165,800                       |        | 4,563 |   | (220,145 | ) |
| Loss  on debt extinguishment                                                   |   | —                        |        | — |   | (503,246 | ) |
| Loss  before cumulative effect of change in accounting principle               |   | (12,423,745                   | )           | (5,932,893 | ) | (4,378,911 | ) |
| Cumulative  effect of change in accounting principle                           |   | (461,000                      | )           | — |   | — |   |
| Net  loss                                                                      |   | (12,884,745                   | )           | (5,932,893 | ) | (4,378,911 | ) |
| Dividends  to preferred stockholders                                           |   | (1,152,819                    | )           | (649,147 | ) | (2,768,394 | ) |
| Net  loss attributable to common stockholders                                  |   | $                             | (14,037,564 | ) | $ | (6,582,040 | ) | $ | (7,147,305 | ) |
|                                                                           |   |                          |        |   |   |   |   |
| Net  loss per share before cumulative effect of change in accounting principle |   | $                             | (17.07      | ) | $ | (5.23 | ) | $ | (4.79 | ) |
| Cumulative  effect of change in accounting principle                           |   | (0.58                         | )           | — |   | — |   |
| Basic  and diluted net loss per share                                          |   | $                             | (17.65      | ) | $ | (5.23 | ) | $ | (4.79 | ) |
| Pro  forma amounts assuming the accounting change is applied retroactively:    |   |                          |        |   |   |   |   |
| Net  loss attributable to common stockholders                                  |   | $                             | (13,576,564 | ) |   |   |   |   |
| Net  loss per share, basic and diluted                                         |   | $                             | (17.00      | ) |   |   |   |   |

 

The accompanyingnotes are an integral part of the financial statements.

 

F-4

----

 

# **VCampus Corporation**

 

**ConsolidatedStatements of Stockholders’ Equity**

** **
|                                                                                                     |   | **Series C Convertible  Preferred Stock** |   | **Series D Convertible  Preferred Stock** |   | **Series E Convertible  Preferred Stock** |      |
|----------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|--------|-------------------------------------------|--------|-------------------------------------------|-----------|
|                                                                                                     |   | **Shares**                                |   | **Amount**                                |   | **Shares**                                |      | **Amount** |   | **Shares** |   | **Amount** |   |
|                                                                                                     |   |                                      |   |                                      |   |                                      |      |   |   |   |   |   |   |
| Balance  at December 31, 1999                                                                            |   | 623,339                                   |   | $                                         | 6,233  |                                      | 1,073,370 |   | $ | 10,734 |   | 214,928 |   | $ | 2,149 |   |
| Issuance  of Series E convertible Preferred Stock                                                        |   | —                                    |   | —                                    |   | —                                    |      | — |   | 963,092 |   | 9,631 |   |
| Issuance  of Series E convertible Preferred Stock for payment of Series E dividends                      |   | —                                    |   | —                                    |   | —                                    |      | — |   | 18,040 |   | 181 |   |
| Issuance  of Common Stock                                                                                |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Conversion  of Preferred Stock to Common Stock                                                           |   | —                                    |   | —                                    |   | (2,727                                    | )         | (28 | ) | (621,503 | ) | (6,215 | ) |
| Issuance  of Common Stock primarily in connection with conversion of debt to equity                      |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Issuance  of Common Stock for payment of Series D Convertible Preferred Stock dividends                  |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Issuance  of Common Stock in connection with exercise of options and exercise of  warrants               |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Cumulative  effect of change in accounting principle.                                                    |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Compensatory  stock, stock options and warrants                                                          |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Net  loss                                                                                                |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Dividends  on convertible preferred stock                                                                |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Balance  at December 31, 2000                                                                            |   | 623,339                                   |   | $                                         | 6,233  |                                      | 1,070,643 |   | $ | 10,706 |   | 574,557 |   | $ | 5,746 |   |
| Issuance  of Series E convertible Preferred Stock                                                        |   | —                                    |   | —                                    |   | —                                    |      | — |   | 187,500 |   | 1,875 |   |
| Issuance  of Preferred Stock-Series E dividends                                                          |   | —                                    |   | —                                    |   | —                                    |      | — |   | 89,472 |   | 895 |   |
| Issuance  of Series F convertible Preferred Stock                                                        |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Issuance  of Common Stock                                                                                |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Conversion  of Preferred Stock to Common Stock                                                           |   | —                                    |   | —                                    |   | (56,834                                   | )         | (568 | ) | (306,454 | ) | (3,065 | ) |
| Issuance  of Common Stock primarily in connection with conversion of debt to equity                      |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Issuance  of common stock-Series D dividends                                                             |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Exercise  of options and warrants                                                                        |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Stock,  stock options and warrants issued for services and in connection with debt  and equity offerings |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Net  loss                                                                                                |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Dividends  on convertible preferred stock                                                                |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Balance  at December 31, 2001                                                                            |   | 623,339                                   |   | $                                         | 6,233  |                                      | 1,013,809 |   | $ | 10,138 |   | 545,075 |   | $ | 5,451 |   |
|                                                                                                     |   |                                      |   |                                      |   |                                      |      |   |   |   |   |   |   |
| Issuance  of Preferred Stock for payment of Series E Dividends                                           |   | —                                    |   | —                                    |   | —                                    |      | — |   | 29,820 |   | 298 |   |
| Issuance  of Series F convertible Preferred Stock                                                        |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Issuance  of Series F-1 convertible Preferred Stock                                                      |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Issuance  of Series F-2 convertible Preferred Stock                                                      |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Issuance  of Series F-2 convertible Preferred Stock-primarily in connection with  cancellation of debt   |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Issuance  of Series G convertible Preferred Stock                                                        |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Series  F convertible Preferred Stock subscribed                                                         |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Issuance  of Common Stock in connection with reverse stock split                                         |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Issuance  of common stock – for payment of Series D dividends                                       |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Exercise  of options & warrants                                                                      |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Compensatory  stock, stock options and warrants                                                          |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Net  loss                                                                                                |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Dividends  on convertible preferred stock                                                                |   | —                                    |   | —                                    |   | —                                    |      | — |   | — |   | — |   |
| Balance  at December 31, 2002                                                                            |   | 623,339                                   |   | $                                         | 6,233  |                                      | 1,013,809 |   | $ | 10,138 |   | 545,075 |   | $ | 5,749 |   |

 
|                                                                                                     |   | **Series F Convertible  Preferred Stock** |   | **Series F-1 Convertible  Preferred Stock** |   | **Series F-2 Convertible  Preferred Stock** |      |
|----------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|--------|---------------------------------------------|--------|---------------------------------------------|-----------|
|                                                                                                     |   | **Shares**                                |   | **Amount**                                  |   | **Shares**                                  |      | **Amount** |   | **Shares** |   | **Amount** |   |
|                                                                                                     |   |                                      |   |                                        |   |                                        |      |   |   |   |   |   |   |
| Balance  at December 31, 1999                                                                            |   | —                                    |   | $                                           | — |                                        | —    |   | $ | — |   | — |   | $ | — |   |
| Issuance  of Series E convertible Preferred Stock                                                        |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Issuance  of Series E convertible Preferred Stock for payment of Series E dividends                      |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Issuance  of Common Stock                                                                                |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Conversion  of Preferred Stock to Common Stock                                                           |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Issuance  of Common Stock primarily in connection with conversion of debt to equity                      |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Issuance  of Common Stock for payment of Series D Convertible Preferred Stock dividends                  |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Issuance  of Common Stock in connection with exercise of options and exercise of  warrants               |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Cumulative  effect of change in accounting principle.                                                    |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Compensatory  stock, stock options and warrants                                                          |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Net  loss                                                                                                |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Dividends  on convertible preferred stock                                                                |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Balance  at December 31, 2000                                                                            |   | —                                    |   | $                                           | — |                                        | —    |   | $ | — |   | — |   | $ | — |   |
| Issuance  of Series E convertible Preferred Stock                                                        |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Issuance  of Preferred Stock-Series E dividends                                                          |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Issuance  of Series F convertible Preferred Stock                                                        |   | 2,642,836                                 |   | 26,428                                      |   | —                                      |      | — |   | — |   | — |   |
| Issuance  of Common Stock                                                                                |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Conversion  of Preferred Stock to Common Stock                                                           |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Issuance  of Common Stock primarily in connection with conversion of debt to equity                      |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Issuance  of common stock-Series D dividends                                                             |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Exercise  of options and warrants                                                                        |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Stock,  stock options and warrants issued for services and in connection with debt  and equity offerings |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Net  loss                                                                                                |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Dividends  on convertible preferred stock                                                                |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Balance  at December 31, 2001                                                                            |   | 2,642,836                                 |   | $                                           | 26,428 |                                        | —    |   | $ | — |   | — |   | $ | — |   |
|                                                                                                     |   |                                      |   |                                        |   |                                        |      |   |   |   |   |   |   |
| Issuance  of Preferred Stock for payment of Series E Dividends                                           |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Issuance  of Series F convertible Preferred Stock                                                        |   | 357,164                                   |   | 3,572                                       |   | —                                      |      | — |   | — |   | — |   |
| Issuance  of Series F-1 convertible Preferred Stock                                                      |   | —                                    |   | —                                      |   | 1,458,413                                   |      | 14,584 |   | — |   | — |   |
| Issuance  of Series F-2 convertible Preferred Stock                                                      |   | —                                    |   | —                                      |   | —                                      |      | — |   | 17,859 |   | 179 |   |
| Issuance  of Series F-2 convertible Preferred Stock-primarily in connection with  cancellation of debt   |   | —                                    |   | —                                      |   | —                                      |      | — |   | 9,719 |   | 97 |   |
| Issuance  of Series G convertible Preferred Stock                                                        |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Series  F convertible Preferred Stock subscribed                                                         |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Issuance  of Common Stock in connection with reverse stock split                                         |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Issuance  of common stock – for payment of Series D dividends                                       |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Exercise  of options & warrants                                                                      |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Compensatory  stock, stock options and warrants                                                          |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Net  loss                                                                                                |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Dividends  on convertible preferred stock                                                                |   | —                                    |   | —                                      |   | —                                      |      | — |   | — |   | — |   |
| Balance  at December 31, 2002                                                                            |   | 3,000,000                                 |   | $                                           | 30,000 |                                        | 1,458,413 |   | $ | 14,584 |   | 27,578 |   | $ | 276 |   |

 
|                                                                                                     |   | **Series G Convertible  Preferred Stock** |       | **Common Stock** |       | **Additional  Paid in Capital** |      | **Preferred  Stock  Subscribed** |   |
|----------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|------------|------------------|------------|---------------------------------|-----------|----------------------------------|--------|
| **Shares**                                                                                               |   | **Amount**                                | **Shares** |             | **Amount** |
|                                                                                                     |   |                                      |       |             |       |                            |      |                             |   |   |   |   |   |
| Balance  at December 31, 1999                                                                            |   | —                                    |       | $                | —     |                            | 568,519   |                             | $      | 5,685 |   | $ | 58,629,233 |   | $ | — |   |
| Issuance  of Series E convertible Preferred Stock                                                        |   | —                                    |       | —           |       | —                          |      | —                           |   | 4,315,006 |   | — |   |
| Issuance  of Series E convertible Preferred Stock for payment of Series E dividends                      |   | —                                    |       | —           |       | —                          |      | —                           |   | (181 | ) | — |   |
| Issuance  of Common Stock                                                                                |   | —                                    |       | —           |       | 205,335                         |      | 2,053                            |   | 6,682,890 |   | — |   |
| Conversion  of Preferred Stock to Common Stock                                                           |   | —                                    |       | —           |       | 62,423                          |      | 624                              |   | 5,619 |   | — |   |
| Issuance  of Common Stock primarily in connection with conversion of debt to equity                      |   | —                                    |       | —           |       | 48,257                          |      | 483                              |   | 1,184,755 |   | — |   |
| Issuance  of Common Stock for payment of Series D Convertible Preferred Stock dividends                  |   | —                                    |       | —           |       | 24,507                          |      | 245                              |   | 295,327 |   | — |   |
| Issuance  of Common Stock in connection with exercise of options and exercise of  warrants               |   | —                                    |       | —           |       | 41,965                          |      | 420                              |   | 876,334 |   | — |   |
| Cumulative  effect of change in accounting principle.                                                    |   | —                                    |       | —           |       | —                          |      | —                           |   | 461,000 |   | — |   |
| Compensatory  stock, stock options and warrants                                                          |   | —                                    |       | —           |       | —                          |      | —                           |   | 361,391 |   | — |   |
| Net  loss                                                                                                |   | —                                    |       | —           |       | —                          |      | —                           |   | — |   | — |   |
| Dividends  on convertible preferred stock                                                                |   | —                                    |       | —           |       | —                          |      | —                           |   | 773,228 |   | — |   |
| Balance  at December 31, 2000                                                                            |   | —                                    |       | $                | —     |                            | 951,006   |                             | $      | 9,510 |   | $ | 73,584,602 |   | $ | — |   |
| Issuance  of Series E convertible Preferred Stock                                                        |   | —                                    |       | —           |       | —                          |      | —                           |   | 186,453 |   | — |   |
| Issuance  of Preferred Stock-Series E dividends                                                          |   | —                                    |       | —           |       | —                          |      | —                           |   | (895 | ) | — |   |
| Issuance  of Series F convertible Preferred Stock                                                        |   | —                                    |       | —           |       | —                          |      | —                           |   | 750,214 |   | (100,000 | ) |
| Issuance  of Common Stock                                                                                |   | —                                    |       | —           |       | 313,738                         |      | 3,137                            |   | 2,912,565 |   | — |   |
| Conversion  of Preferred Stock to Common Stock                                                           |   | —                                    |       | —           |       | 36,328                          |      | 363                              |   | 3,270 |   | — |   |
| Issuance  of Common Stock primarily in connection with conversion of debt to equity                      |   | —                                    |       | —           |       | 118,378                         |      | 1,184                            |   | 1,156,554 |   | — |   |
| Issuance  of common stock-Series D dividends                                                             |   | —                                    |       | —           |       | 49,461                          |      | 495                              |   | 278,298 |   | — |   |
| Exercise  of options and warrants                                                                        |   | —                                    |       | —           |       | 85                              |      | 1                                |   | 101 |   | — |   |
| Stock,  stock options and warrants issued for services and in connection with debt  and equity offerings |   | —                                    |       | —           |       | 872                             |      | 9                                |   | 1,001,730 |   | — |   |
| Net  loss                                                                                                |   | —                                    |       | —           |       | —                          |      | —                           |   | — |   | — |   |
| Dividends  on convertible preferred stock                                                                |   | —                                    |       | —           |       | —                          |      | —                           |   | 37,615 |   | — |   |
| Balance  at December 31, 2001                                                                            |   | —                                    |       | $                | —     |                            | 1,469,868 |                             | $      | 14,699 |   | $ | 79,910,507 |   | $ | (100,000 | ) |
|                                                                                                     |   |                                      |       |             |       |                            |      |                             |   |   |   |   |   |
| Issuance  of Preferred Stock for payment of Series E Dividends                                           |   | —                                    |       | —           |       | —                          |      | —                           |   | 10,655 |   | — |   |
| Issuance  of Series F convertible Preferred Stock                                                        |   | —                                    |       | —           |       | —                          |      | —                           |   | 121,435 |   | — |   |
| Issuance  of Series F-1 convertible Preferred Stock                                                      |   | —                                    |       | —           |       | —                          |      | —                           |   | 583,894 |   | — |   |
| Issuance  of Series F-2 convertible Preferred Stock                                                      |   | —                                    |       | —           |       | —                          |      | —                           |   | 604,886 |   | — |   |
| Issuance  of Series F-2 convertible Preferred Stock-primarily in connection with  cancellation of debt   |   | —                                    |       | —           |       | —                          |      | —                           |   | 594,198 |   | — |   |
| Issuance  of Series G convertible Preferred Stock                                                        |   | 49,320                                    |       | 492              |       | —                          |      | —                           |   | 1,256,337 |   | — |   |
| Series  F convertible Preferred Stock subscribed                                                         |   | —                                    |       | —           |       | —                          |      | —                           |   | — |   | 100,000 |   |
| Issuance  of Common Stock in connection with reverse stock split                                         |   | —                                    |       | —           |       | 73                              |      | —                           |   | — |   | — |   |
| Issuance  of common stock – for payment of Series D dividends                                       |   | —                                    |       | —           |       | 81,325                          |      | 813                              |   | 277,952 |   | — |   |
| Exercise  of options & warrants                                                                      |   | —                                    |       | —           |       | 1,844                           |      | 19                               |   | 1,078 |   | — |   |
| Compensatory  stock, stock options and warrants                                                          |   | —                                    |       | —           |       | 20,794                          |      | 208                              |   | 2,410,679 |   | — |   |
| Net  loss                                                                                                |   | —                                    |       | —           |       | —                          |      | —                           |   | — |   | — |   |
| Dividends  on convertible preferred stock                                                                |   | —                                    |       | —           |       | —                          |      | —                           |   | — |   | — |   |
| Balance  at December 31, 2002                                                                            |   | 49,320                                    |       | $                | 492        |                            | 1,573,904 |                             | $      | 15,739 |   | $ | 85,771,622 |   | $ | — |   |

 
|                                                                                                     |   | **Accumulated Defecit** |        | **Total Stockholder’s Equity** |   |
|----------------------------------------------------------------------------------------------------------|--------|-------------------------|-------------|-------------------------------------|--------|
|                                                                                                     |   |                    |        |                                |   |
| Balance  at December 31, 1999                                                                            |   | $                       | (56,631,829 | )                                   | $      | 2,022,205 |   |
| Issuance  of Series E convertible Preferred Stock                                                        |   | —                  |        | 4,324,637                           |   |
| Issuance  of Series E convertible Preferred Stock for payment of Series E dividends                      |   | —                  |        | —                              |   |
| Issuance  of Common Stock                                                                                |   | —                  |        | 6,684,943                           |   |
| Conversion  of Preferred Stock to Common Stock                                                           |   | —                  |        | —                              |   |
| Issuance  of Common Stock primarily in connection with conversion of debt to equity                      |   | —                  |        | 1,185,238                           |   |
| Issuance  of Common Stock for payment of Series D Convertible Preferred Stock dividends                  |   | —                  |        | 295,572                             |   |
| Issuance  of Common Stock in connection with exercise of options and exercise of  warrants               |   | —                  |        | 876,754                             |   |
| Cumulative  effect of change in accounting principle.                                                    |   | —                  |        | 461,000                             |   |
| Compensatory  stock, stock options and warrants                                                          |   | —                  |        | 361,391                             |   |
| Net  loss                                                                                                |   | (12,884,745             | )           | (12,884,745                         | )      |
| Dividends  on convertible preferred stock                                                                |   | (1,068,842              | )           | (295,614                            | )      |
| Balance  at December 31, 2000                                                                            |   | $                       | (70,585,416 | )                                   | $      | 3,031,381 |   |
| Issuance  of Series E convertible Preferred Stock                                                        |   | —                  |        | 188,328                             |   |
| Issuance  of Preferred Stock-Series E dividends                                                          |   | —                  |        | —                              |   |
| Issuance  of Series F convertible Preferred Stock                                                        |   | —                  |        | 676,642                             |   |
| Issuance  of Common Stock                                                                                |   | —                  |        | 2,915,702                           |   |
| Conversion  of Preferred Stock to Common Stock                                                           |   | —                  |        | —                              |   |
| Issuance  of Common Stock primarily in connection with conversion of debt to equity                      |   | —                  |        | 1,157,738                           |   |
| Issuance  of common stock-Series D dividends                                                             |   | —                  |        | 278,793                             |   |
| Exercise  of options and warrants                                                                        |   | —                  |        | 102                                 |   |
| Stock,  stock options and warrants issued for services and in connection with debt  and equity offerings |   | (225,000                | )           | 776,739                             |   |
| Net  loss                                                                                                |   | (5,932,893              | )           | (5,932,893                          | )      |
| Dividends  on convertible preferred stock                                                                |   | (316,414                | )           | (278,799                            | )      |
| Balance  at December 31, 2001                                                                            |   | $                       | (77,059,723 | )                                   | $      | 2,813,733 | ) |
|                                                                                                     |   |                    |        |                                |   |
| Issuance  of Preferred Stock for payment of Series E Dividends                                           |   | (10,954                 | )           | (1                                  | )      |
| Issuance  of Series F convertible Preferred Stock                                                        |   | —                  |        | 125,007                             |   |
| Issuance  of Series F-1 convertible Preferred Stock                                                      |   | (44,282                 | )           | 554,196                             |   |
| Issuance  of Series F-2 convertible Preferred Stock                                                      |   | —                  |        | 605,065                             |   |
| Issuance  of Series F-2 convertible Preferred Stock-primarily in connection with  cancellation of debt   |   | (81,894                 | )           | 512,401                             |   |
| Issuance  of Series G convertible Preferred Stock                                                        |   | (198,166                | )           | 1,058,663                           |   |
| Series  F convertible Preferred Stock subscribed                                                         |   | —                  |        | 100,000                             |   |
| Issuance  of Common Stock in connection with reverse stock split                                         |   | —                  |        | —                              |   |
| Issuance  of common stock – for payment of Series D dividends                                       |   | —                  |        | 278,765                             |   |
| Exercise  of options & warrants                                                                      |   | —                  |        | 1,097                               |   |
| Compensatory  stock, stock options and warrants                                                          |   | (2,154,298              | )           | 256,590                             |   |
| Net  loss                                                                                                |   | (4,378,911              | )           | (4,378,911                          | )      |
| Dividends  on convertible preferred stock                                                                |   | (278,800                | )           | (278,800                            | )      |
| Balance  at December 31, 2002                                                                            |   | $                       | (84,207,028 | )                                   | $      | 1,647,805 |   |

 

The accompanyingnotes are an integral part of the financial statements.

 

F-5

----

 

**VCAMPUS CORPORATION**

 

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

 
|                                                                                          |   | **Years  ended December 31,** |        |
|-----------------------------------------------------------------------------------------------|--------|-------------------------------|-------------|
|                                                                                          |   | **2000**                      |        | **2001** |   | **2002** |   |
| **Operating  Activities**                                                                     |   |                          |        |   |   |   |   |
| Net  loss                                                                                     |   | $                             | (12,884,745 | ) | $ | (5,932,893 | ) | $ | (4,378,911 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities:                  |   |                          |        |   |   |   |   |
| Depreciation                                                                                  |   | 1,186,190                     |        | 1,095,703 |   | 694,998 |   |
| Amortization                                                                                  |   | 1,729,962                     |        | 1,058,449 |   | 660,839 |   |
| Bad  debt expense                                                                             |   | —                        |        | — |   | 6,833 |   |
| Loss  on debt extinguishment                                                                  |   | —                        |        | — |   | 503,246 |   |
| Impairment  of capitalized software and courseware development costs                          |   | —                        |        | — |   | 276,535 |   |
| Non-cash  stock option and stock warrant expense                                              |   | 361,391                       |        | 444,090 |   | 76,172 |   |
| Write-off  of intangible assets                                                               |   | 1,226,335                     |        | — |   | — |   |
| Write-off  of other assets                                                                    |   | 700,918                       |        | — |   | — |   |
| Write-off  of note receivable                                                                 |   | —                        |        | — |   | 120,693 |   |
| Debt  discount amortization                                                                   |   | —                        |        | — |   | 214,574 |   |
| Cumulative  effect of change in accounting principle                                          |   | 461,000                       |        | — |   | — |   |
| Increase  (decrease) in allowance for doubtful accounts                                       |   | 76,239                        |        | (118,471 | ) | (68,386 | ) |
| Changes  in operating assets and liabilities:                                                 |   |                          |        |   |   |   |   |
| Accounts  receivable                                                                          |   | 567,118                       |        | 156,266 |   | 382,225 |   |
| Prepaid  expenses and other current assets                                                    |   | 134,313                       |        | 93,746 |   | (438,353 | ) |
| Other  assets                                                                                 |   | (69,696                       | )           | 7,798 |   | 52,440 |   |
| Accounts  payable and accrued expenses                                                        |   | (2,529,207                    | )           | (296,903 | ) | (543,645 | ) |
| Deferred  revenues                                                                            |   | (425,713                      | )           | 238,322 |   | (220,889 | ) |
| Net  cash used in operating activities                                                        |   | (9,465,895                    | )           | (3,253,893 | ) | (2,661,629 | ) |
| **Investing  Activities**                                                                     |   |                          |        |   |   |   |   |
| Purchases  of property and equipment                                                          |   | (1,417,720                    | )           | (32,863 | ) | (85,539 | ) |
| Capitalized  courseware development costs                                                     |   | (625,528                      | )           | (453,257 | ) | (383,789 | ) |
| Proceeds  from loans receivable from related party                                            |   | —                        |        | — |   | 23,097 |   |
| Interest  on loans receivable from related party                                              |   | (8,000                        | )           | (8,001 | ) | (6,500 | ) |
| Proceeds  from sale of subsidiaries                                                           |   | 300,334                       |        | — |   | — |   |
| Proceeds  from loans receivable                                                               |   | —                        |        | 63,267 |   | 37,085 |   |
| Advances  under loans receivable                                                              |   | (81,506                       | )           | (10,199 | ) | (6,792 | ) |
| Net  cash used in investing activities                                                        |   | (1,832,420                    | )           | (441,053 | ) | (422,438 | ) |
| **Financing  Activities**                                                                     |   |                          |        |   |   |   |   |
| Proceeds  from issuance of Common Stock                                                       |   | 7,548,061                     |        | 2,763,701 |   | 1,096 |   |
| Proceeds  from the issuance of Series E convertible Preferred Stock                           |   | 4,324,637                     |        | 188,328 |   | — |   |
| Proceeds  from the issuance of Series F convertible Preferred Stock, net of offering  costs   |   | —                        |        | 752,642 |   | 225,007 |   |
| Proceeds  from the issuance of Series F-2 convertible Preferred Stock, net of offering  costs |   | —                        |        | — |   | 605,065 |   |
| Proceeds  from the issuance of Series G convertible Preferred Stock, net of offering  costs   |   | —                        |        | — |   | 1,058,663 |   |
| Payments  on capital lease obligations                                                        |   | —                        |        | (127,799 | ) | (206,069 | ) |
| Proceeds  from notes payable                                                                  |   | —                        |        | 1,902,641 |   | 100,000 |   |
| Repayments  of notes payable                                                                  |   | (535,634                      | )           | — |   | — |   |
| Net  cash provided by financing activities                                                    |   | 11,337,064                    |        | 5,479,513 |   | 1,783,762 |   |
| Net  (decrease) increase in cash and cash equivalents                                         |   | 38,749                        |        | 1,784,567 |   | (1,300,305 | ) |
| Cash  and cash equivalents at the beginning of the year                                       |   | 204,455                       |        | 243,204 |   | 2,027,771 |   |
| Cash  and cash equivalents at the end of the year                                             |   | $                             | 243,204     |   | $ | 2,027,771 |   | $ | 727,466 |   |
| **Supplemental  cash flow information:**                                                      |   |                          |        |   |   |   |   |
| Interest  paid                                                                                |   | $                             | 26,600      |   | $ | — |   | $ | — |   |

 

The accompanyingnotes are an integral part of the financial statements.

 

F-6

----

 

**VCAMPUS CORPORATION**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

**1.             Organizationand Nature of Operations**

 

VCampus Corporation  (the “Company”) was incorporated in Virginiain 1984 and reincorporated in Delaware in 1985.  The Company is a leading e-learning Application Services Provider,or ASP, that manages and hosts turnkey, Internet-based learning environmentsfor corporations, government agencies, institutions of higher education, andassociations. The Company has developed proprietary software for the creationand hosting of a virtual campus, or “vcampus,” that enables its customers tooffer Internet-based training to their customers, sales channel partners,employees and students. The Company’s services cover a broad range ofe-learning programs, from enrollment and payment to course development anddelivery, as well as tracking of students’ progress and reporting of theresults.

 

**2.             Summaryof Significant Accounting Policies**

 

*Principles of Consolidation*

 

The consolidated financial statements include theaccounts of the Company and its wholly-owned subsidiaries. All significantintercompany accounts and transactions have been eliminated.

 

*Use of Estimates*

 

The preparation of the consolidated financialstatements in conformity with generally accepted accounting principles requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the consolidated financial statements and the reported amountsof revenues and expenses during the reporting period. Actual results coulddiffer from those estimates.

 

*Cash Equivalents*

 

Cash equivalents, which are stated at cost, consist ofhighly liquid investments with original maturities of three months or less.

 

#### *Non-Cash FinancingActivities*

 

In August 2001, the Company issued 10,000 shares ofits common stock with a value of $152,000 to a third party who assisted theCompany with its financing activities. Upon completion of the December 2001 debt and equity financing, $76,000of the total value of the shares was allocated to the Series F Preferred Stockoffering as an equity issuance cost. The remaining amount was allocated to the 8% debentures as deferred debtissuance costs and will be recognized as interest expense over the period thedebentures are expected to be outstanding.

 

*Loans Receivable*

 

The Company periodically assesses the collectibilityof its loans receivable and records balances due at the amount it believesit will be able to collect during the term of the loan.  At December 31, 2001, the Company had a loanreceivable resulting from the 1999 sale of HTR’s Knowledgeworks businesstotaling approximately $123,000.  During2002, the Company determined that the loan receivable was impaired and wrote offthe remaining balance totaling approximately $121,000.  The Company recognized interest incomerelated to this loan receivable as earned.The Company recognized interest income related to this loan receivable ofapproximately $64,171 for the year ended December 31, 2000. No interest incomewas recognized for the years ended December 31, 2001 and 2002.

 

*Capitalized Software and Courseware Development Costs*

 

During 2000, 2001 and2002, the Company capitalized certain software and courseware developmentcosts. The Company capitalizes costs incurred during the development process,including payroll costs for employees who are directly associated with thedevelopment process and services performed by consultants. Amortization of suchcosts is based on the greater of (1) the ratio of current gross revenues to thesum of current and anticipated gross revenues, or (2) the straight-line methodover the remaining 

 

F-7

----

 

economic life of theVCampus or courseware, typically two to three years.  It is possible that those anticipated gross revenues, theremaining economic life of the products, or both, may be reduced as a result offuture events.  During 2000, 2001 and2002, the Company recognized amortization of capitalized software andcourseware development costs of $942,144, $533,931 and $438,754,respectively.  During 2002, the Companywrote off $276,535 in capitalized software and courseware development costs forcourses within the telecommunications industry segment determined to have nofuture value.  The write-off, whichrepresents the carrying value of the courses, has been included in productdevelopment costs in the 2002 statements of operations.

 

#### *Web SiteDevelopment Costs*

 

The Company accounts for web site development costs inaccordance with Emerging Issues Task Force Issue No. 00-2*, Accounting for Web Site Development Costs*(“EITF00-2”).  The implementation of EITF 00-2did not have a material impact on the Company’s financial position or resultsof operations.  In 2000, 2001 and 2002all web site development costs were incurred in the operating stage, includingmaintenance and minor enhancements and upgrades, and were expensed as incurred.

 

*Goodwill and Other Intangible Assets*

 

Goodwill and other intangibles represent theunamortized excess of the cost of acquiring subsidiary companies over the fairvalues of such companies’ net tangible assets at the dates of acquisition.

 

On January 1, 2002, the Company adopted Statement ofFinancial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other IntangibleAssets” (SFAS 142).  In accordance withthe provisions of SFAS 142, the Company reclassified the net carrying value ofits workforce intangible asset recognized in connection with the acquisition ofHTR, Inc. ($57,818) into goodwill on January 1, 2002.  The workforce asset was comprised of at-will employees and nolonger met the criteria for recognition apart from goodwill.  Amortization of goodwill, including goodwillpreviously identified as a workforce intangible, ceased on January 1,2002.  The Company does not have anyindefinite-lived intangibles.  Inaccordance with SFAS 142, the Company reviewed the useful lives of itsintangible assets and determined that they remained appropriate.

 

In connection with the adoption of SFAS 142, theCompany performed an assessment of whether there were indicators that goodwillwas impaired at the date of adoption. To accomplish this, the Companyidentified its reporting units and determined the carrying value of eachreporting unit. The Company then determined the fair value of the reportingunit and compared it to the reporting unit’s carrying amount. To the extent thereporting unit’s carrying amount exceeds its fair value, an indication existsthat the reporting unit’s goodwill may be impaired and the Company must performthe second step of the impairment test. In the second step, the Company must compare the implied fair value ofthe reporting unit’s goodwill, determined by allocating the reporting unit’sfair value to all of its assets and liabilities in a manner similar to apurchase price allocation in accordance with SFAS 141, to its carrying amount,both of which would be measured as of the date of adoption.

 

The Company performed the initial goodwill impairmenttest required by SFAS 142 during the second quarter of fiscal 2002.  The Company considers itself to be a singlereporting unit.  Accordingly, all of theCompany’s goodwill is associated with the entire Company.  The Company performed its initial  impairment test and as of June 30, 2002,based on the Company’s market capitalization, there was no impairment ofgoodwill recorded upon implementation of SFAS 142.  The Company will continue to test for impairment on an annualbasis, coinciding with its fiscal year end, or on an interim basis ifcircumstances change that would more likely than not reduce the fair value ofthe Company’s reporting unit below its carrying amount.

 

*Impairment of Long-Lived Assets*

 

The Company accounts for long-lived assets inaccordance with the provisions of SFAS No. 144, *Accounting for the Impairment or Disposal of Long-Lived Assets*(SFAS No. 144).  SFAS No. 144 requiresthat long-lived assets and certain identifiable intangibles be reviewed forimpairment whenever events or changes in circumstances indicate that thecarrying amount of an asset may not be recoverable.  Recoverability of assets is measured by comparing the carryingamount of an asset to future undiscounted net cash flows expected to begenerated by the asset.  If such assetsare considered to be impaired, the impairment to be recognized is measured bythe amount by which the carrying amount of the assets exceeds the fair value ofthe assets.  Assets to be disposed of bysale are reflected at the lower of their carrying amount or fair value lesscost to sell.

 

During 2000, the Company wrote off the remaininggoodwill, $1,226,000, recorded in connection with the acquisition of HTR as aresult of its decision to discontinue the majority of HTR’s non- onlinebusinesses as described in Note 7.

 

F-8

----

 

During 2002, the Company wrote off $276,535 incapitalized software and courseware development costs for courses within thetelecommunications industry segment, as a result of an impairmentanalysis.  The write-off has been includedin product development costs in the 2002 statement of operations.

 

*Revenue Recognition*

 

The Company currently derivesits revenues from the following sources — online tuition revenues, developmentand other revenues and other service revenues.

 

Online tuition revenues aregenerated primarily through three types of contracts: (i) higher educationpartners, (ii) corporate subscriptions, and (iii) corporate usage.  For higher education partners and corporatesubscriptions, revenue is recognized ratably over the semester term andsubscription period, respectively.  Forcorporate usage contracts, revenue is recognized upon enrollment in acourse.  Once a student has enrolled in acourse, he cannot cancel delivery of a course or receive a refund.  Initial set-up fees related to all onlinetuition services are recognized ratably over the respective contract term.

 

Development and otherrevenues earned under courseware conversion contracts are recognized relativeto the Company’s proportionate performance based on the ratio that total costsincurred to date bear to the total estimated costs of the contract. Provisionsfor losses on contracts are made in the period in which they are determined.

 

Revenues for other servicesare recognized as the services are delivered.

 

In 2000, one customerrepresented approximately 12% of net revenues. In 2001 and 2002 two customers represented 19% and 11% and 31% and 11%,respectively, of  net revenues.

 

*Stock-Based Compensation*

 

SFAS No. 123, *Accountingfor Stock-Based Compensatio*n, allows companies to account forstock-based compensation using either the provisions of SFAS No. 123 or theprovisions of Accounting Principles Board Opinion (APB) No. 25, *Accounting for Stock Issued to Employees,*butrequires pro forma disclosure in the notes to the consolidated financialstatements as if the measurement provisions of SFAS No. 123 had been adopted.The Company accounts for its stock-based employee compensation in accordancewith APB No. 25.

 

Stock options and warrants granted to nonemployees areaccounted for using the fair value method in accordance with the SFAS No. 123and EITF 96-18, *Accounting for EquityInstruments That Are Issued to Other Than Employees for Acquiring, or inConjunction with Selling, Goods or Service*s.

 

The following table illustrates the pro forma effecton net loss attributable to common stockholders (net loss) and pro forma netloss per common share as if the Company had applied the fair value recognitionprovisions of SFAS No. 123 to stock-based compensation.

 

|                                                                                                                 |   | **2000**   |        | **2001**   |   | **2002**    |   |
|----------------------------------------------------------------------------------------------------------------------|--------|------------|-------------|------------|--------|-------------|--------|
| Pro  forma net loss:                                                                                                 |   |       |        |       |   |        |   |
| As  reported                                                                                                         |   | $          | (14,037,564 | )          | $      | (6,582,040  | )      | $ | (7,147,305 | ) |
| Add:  Non cash stock compensation included in reported net loss attributable to  common stockholders                 |   | 361,391    |        | 440,898    |   | 76,172      |   |
| Deduct:  Total employee non cash stock compensation expense determined under fair  value based method for all awards |   | (5,502,008 | )           | (5,501,385 | )      | (4,996,214  | )      |
| Pro  forma net loss                                                                                                  |   | $          | (19,178,181 | )          | $      | (11,642,527 | )      | $ | (12,067,347 | ) |
|                                                                                                                 |   |       |        |       |   |        |   |
| Net  loss per common share:                                                                                          |   |       |        |       |   |        |   |
| Basic  and diluted—as reported                                                                                  |   | $          | (17.65      | )          | $      | (5.23       | )      | $ | (4.79 | ) |
| Basic  and diluted—pro forma                                                                                    |   | $          | (24.11      | )          | $      | (9.25       | )      | $ | (8.08 | ) |

 

F-9

----

 

The effect of applying SFAS No. 123 on a pro forma net loss as statedabove is not necessarily representative of the effects on reported net loss forfuture years due to, among other things, the vesting period of the stockoptions and the fair value of additional options to be granted in the futureyears.

 

The fair value of each option grant is estimated onthe date of grant using the Black-Scholes option-pricing fair value model withthe following assumptions:

 

|                             |   | **2000** |   | **2001** |   | **2002** |   |
|----------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                             |   |     |   |     |   |     |   |
| Dividend  yield                  |   | 0        | %      | 0        | %      | 0        | %      |
| Volatility                       |   | 69       | %      | 133      | %      | 133      | %      |
| Average  risk-free interest rate |   | 6.50     | %      | 4.78     | %      | 4.39     | %      |
| Expected  term                   |   | 7 years  |   | 7 years  |   | 7 years  |   |

 

*Concentration of Credit Risk*

 

The Company performs ongoing credit evaluations of itscustomers’ financial condition and generally does not require collateral. TheCompany maintains reserves for credit losses, and such losses have been withinmanagement’s expectations.

 

Two customers represented 12% and 13%, respectively ofaccounts receivable at December 31, 2001. One customer represented 19% of accounts receivable at December 31,2002.

#### * *

#### *FinancialInstruments*

 

The carrying value of the Company’s financialinstruments, including cash and cash equivalents, accounts receivable, accountspayable, loans receivable and loans payable approximates their fair values.

 

*Royalties*

 

Royalties are due and payable by the Company upon thesale of certain courses for which the Company has acquired or otherwiselicensed the online publishing rights. In addition, the Company may beobligated to pay certain royalties related to courses which a customer may haveconverted to an online format and elected to distribute to all the Company’scustomers. Royalties accrue at a rate of 10% to 85% of the tuition feesreceived with respect to certain courses.

 

Royalties are classified as a cost of revenues and amountedto approximately $436,000, $675,000 and $1,325,000 during the years endedDecember 31, 2000, 2001 and 2002, respectively.

 

*Advertising Costs*

 

The Company expenses advertising costs asincurred.  Advertising costs amounted toapproximately  $606,000, $49,000 and $0for the years ended December 31, 2000, 2001, and 2002 respectively.

 

*Income Taxes*

 

The Company provides for income taxes in accordancewith the liability method.  Under thismethod, deferred tax assets and liabilities are determined based on differencesbetween financial reporting and tax bases of assets and liabilities and aremeasured using the enacted tax rates and laws that are expected to be in effectwhen the differences are expected to reverse. Because the realization of taxbenefits related to the Company’s net deferred tax asset is uncertain, a fullvaluation allowance has been provided against the net deferred tax asset.

 

*Changein Accounting Principle*

 

During the fourth quarter of 2000, the Company implemented EmergingIssues Task Force Issue No. 00-27, Application of EITF Issue No. 98-5, *“Accounting for Convertible Securities withBeneficial Conversion Features or Contingently Adjustable Conversion Ratios,”to Certain Convertible Instruments* (“EITF 00-27”).  Issue 1 of EITF 00-27 modified thecalculation of beneficial conversion 

 

F-10

----

 

features for convertible securities issued with detachable instrumentsfor all transactions subject to EITF Issue No. 98-5.  Companies are required to report any changes in a beneficialconversion feature as a result of applying Issue 1 of EITF 00-27 as acumulative effect of a change in accounting principle at the time ofimplementation in accordance with APB Opinion No. 20, *Accounting Changes*.  As a result of the implementation of EITF00-27, in 2000 the Company recorded a charge of $461,000, or $0.58 per share,as a cumulative effect of a change in accounting principle.

 

*Net Loss Per Share*

 

The Company follows the provisions of SFAS No. 128, *Earnings perShare*(“SFAS No. 128”) which requires the Company to present basicand diluted earnings per share. Basic earnings per share is based on theweighted-average shares outstanding and excludes any dilutive effects ofoptions, warrants and convertible securities. Diluted earnings per shareincreases the shares used in the basic calculation by the dilutive effect ofstock options, warrants, and convertible preferred stock.  For all years presented, common stock equivalentsrelated to stock options, warrants, and convertible preferred stock have beenexcluded from diluted earnings per share because their effect is anti-dilutive.

 

*Comprehensive Income*

 

SFAS No. 130, *Reporting of Comprehensive Income* (“SFASNo. 130”), establishes standards for the display of comprehensive income andits components in a full set of financial statements. Comprehensive incomeincludes all changes in equity during a period except those resulting from theissuance of shares of stock and distributions to shareholders. There were no differencesbetween net loss and comprehensive loss for any period presented.

 

*Recent Accounting Pronouncements*

 

In April 2002, the FinancialAccounting Standards Board issued SFAS No. 145, *Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB StatementNo. 13, and Technical Corrections* (SFAS 145).  Among other things, SFAS 145 generallyprohibits the classification of gains or losses from the early extinguishmentof debt as an extraordinary item, and therefore rescinds the previousrequirement to do so. Gains and losses from prior early debt extinguishmentsare required to be reclassified. The Statement was not required to beimplemented until 2003, though earlier application was encouraged. The Companyelected to adopt the SFAS 145 in 2002 and, accordingly, no amounts related tothe extinguishment of debt was classified as extraordinary in 2002.

 

In June 2002, the FinancialAccounting Standards Board issued SFAS No. 146, *Accounting for Costs Associated with Exit or Disposal of Activities*(SFAS No. 146).  SFAS No. 146 nullifiesprevious accounting guidance and requires that a liability for a costassociated with an exit or disposal activity be recognized when the liabilityis incurred.  The provisions of SFAS No.146 are effective for exit or disposal activities that are initiated afterDecember 31, 2002.  The Company does notexpect the adoption of this statement to have a material impact on itsfinancial position, results of operations, or liquidity.

 

#### *Management’s Plans*

 

The Company has incurred significant losses in thecurrent and prior periods.  The Companyexpects negative cash flow from operations to continue until the online revenuestream matures. The Company believes it has access to adequate resources tofund operations until operations reach cash flow positive.  However, in the event revenues do not meetanticipated levels or the Company is unable to raise additional funding to meetworking capital requirements, the Company may need to further reduce operatingexpenses. If the Company is unable to raise additional funding to meet workingcapital requirements, it may be unable to maintain compliance with Nasdaq SmallCap market listing requirements.  TheCompany believes it has available sources for debt or equity capital in amountsnecessary to, in addition to operating sources, meet its cash needs through2003.  However, such capital may nothave terms favorable to the Company or its current stockholders.

 

If the Company does not addressits funding needs, it will be materially adversely affected. The Company’sfuture capital requirements will depend on many factors, including, but notlimited to, acceptance of and demand for its products and services, customerdemands for technology upgrades, the types of arrangements that the Company mayenter into with customers and resellers, and the extent to which the Companyinvests in new technology and research and development projects.

 

F-11

----

 

**3.             Propertyand Equipment**

 

Property and equipment,including leasehold improvements, are recorded at cost. Depreciation iscalculated using the straight-line method over an estimated useful life of twoto seven years. Leasehold improvements are amortized over the lesser of therelated lease term or the useful life. Depreciation expense on equipment obtained under capital leaseobligations is included with depreciation expense for similar types ofequipment.  Property and equipment consistedof the following:

 

 

|                           |   | **December  31,** |      |
|--------------------------------|--------|-------------------|-----------|
|                           |   | **2001**          |      | **2002** |   |
| Equipment                      |   | $                 | 3,190,903 |   | $ | 3,265,065 |   |
| Computer  software             |   | 970,512           |      | 973,286 |   |
| Leasehold  improvements        |   | 152,118           |      | 152,118 |   |
| Furniture  and fixtures        |   | 570,650           |      | 572,218 |   |
|                           |   | 4,884,183         |      | 4,962,687 |   |
| Less  accumulated depreciation |   | (3,939,388        | )         | (4,634,391 | ) |
| Total                          |   | $                 | 944,795   |   | $ | 328,296 |   |

 

Equipment recorded undercapital lease obligations aggregated $394,695 and  $387,662 at December 31, 2001 and 2002, respectively.  Accumulated depreciation of assets undercapital lease obligations totaled $162,366 and $325,932 at December 31, 2001and 2002, respectively.

 

**4.             CapitalizedSoftware and Courseware Development Costs**

 

Capitalized software and courseware development costsconsisted of the following:

 

|                                      |   | **December  31,** |      |
|-------------------------------------------|--------|-------------------|-----------|
|                                      |   | **2001**          |      | **2002** |   |
| Capitalized  software costs               |   | $                 | 3,200,454 |   | $ | 3,584,243 |   |
| Capitalized  courseware development costs |   | 1,214,259         |      | 937,724 |   |
|                                      |   | 4,414,713         |      | 4,521,967 |   |
| Less  accumulated amortization            |   | (3,268,483        | )         | (3,707,237 | ) |
| Total                                     |   | $                 | 1,146,230 |   | $ | 814,730 |   |

 

**5.             AcquiredOnline Publishing Rights**

 

Acquired online publishing rights consisted of thefollowing:

 

|                               |   | **December  31,  2001** |    |
|------------------------------------|--------|-------------------------|---------|
| Acquired  online publishing rights |   | $                       | 410,000 |   |
| Less  accumulated amortization     |   | (403,770                | )       |
| Total                              |   | $                       | 6,230   |   |

 

At December 31, 2002,acquired online publishing rights were fully amortized.  The Company has written off the total costand related accumulated amortization at December 31, 2002.

 

**6.             Goodwilland Other Intangible Assets**

 

Goodwill and other intangible assets were comprisedof: 

 

|                           |   | **Decemb er  31,** |    |
|--------------------------------|--------|--------------------|---------|
|                           |   | **2001**           |    | **2002** |   |
| Goodwill                       |   | $                  | 814,509 |   | $ | 814,509 |   |
| Less  accumulated amortization |   | (486,192           | )       | (486,192 | ) |
|                           |   | $                  | 328,317 |   | $ | 328,317 |   |

 

|                           |   | **December  31,** |    |
|--------------------------------|--------|-------------------|---------|
|                           |   | **2001**          |    | **2002** |   |
| Developed  content             |   | 1,223,800         |    | 523,800 |   |
| Trademarks  and names          |   | 904,720           |    | 904,720 |   |
| Customer  base                 |   | 304,820           |    | 304,820 |   |
|                           |   | 2,433,340         |    | 1,733,340 |   |
| Less  accumulated amortization |   | (1,468,993        | )       | (984,848 | ) |
|                           |   | $                 | 964,347 |   | $ | 748,492 |   |
|                                |        |                   |         |  |  |  |  |

 

F-12

----

 

In 2000, as a result of the restructuring of HTR, Inc.(“HTR”) non-online business, the Company wrote off approximately $1,226,000,which was the remaining net unamortized goodwill balance that had resulted fromthe acquisition of HTR.  This write-offis included in reorganization and other non-recurring charges in the 2000 statementof operations.  See Note 8.

 

Amortization expense for other intangible assets isexpected to be as follows:

 
| 2003   |   | 210,579  |   |
|--------|--------|----------|--------|
| 2004   |   | 210,579  |   |
| 2005   |   | 157,536  |   |
| 2006   |   | 131,014  |   |
| 2007   |   | 38,784   |   |
|   |   | $748,492 |   |

 

Amortization expense related to intangible assetssubject to amortization totaled $390,850, $361,693 and $215,855 at December 31,2000, 2001 and 2002, respectively.

 

With the adoption of SFAS 142, amortization ofgoodwill was discontinued as of January 1, 2002.  The following information reconciles reported net lossattributable to common stockholders to adjusted net loss, including goodwillamortization previously recorded.

 

|                                                        |   | **2000** |        | **2001** |   |
|-------------------------------------------------------------|--------|----------|-------------|----------|--------|
| Pro  forma net loss:                                        |   |     |        |     |   |
| As  reported                                                |   | $        | (14,037,564 | )        | $      | (6,582,040 | ) |
| Impact  of SFAS 142                                         |   | 266,763  |        | 128,447  |   |
| Pro  forma net loss                                         |   | $        | (13,770,801 | )        | $      | (6,453,593 | ) |
|                                                        |   |     |        |     |   |
| Pro  forma net loss per common share—basic and diluted |   | ($17.31  | )           | ($5.13   | )      |

 

**7.             Dispositions**

 

*HTR, Inc.*

 

In December 2000, the Company announced its decisionto discontinue the majority of HTR’s non-online business.  The Company determined that the remaininggoodwill related to HTR at the time of the decision was impaired under theguidance in SFAS 121.  The Companycompared the carrying value of the HTR goodwill to its fair value as determinedusing the present value of the projected net cash flows of the remaining HTRnon-online operations.  This analysisresulted in a write off of approximately $1,226,000 of goodwill related to thenon-online businesses.

 

**8.             Restructuringof Operations and Other Non-Recurring Items**

 

During 2000, the Company implemented a plan to closecertain office facilities related to HTR’s non-online business. The planresulted in the closure of the Company’s facilities located in Dallas, Texas,Rockville, Maryland and Washington, D.C. As a result, the Company recorded a restructuring charge ofapproximately $335,000 in 2000 included in reorganization and othernon-recurring charges in the 2000 statement of operations. The restructuringcharge included expenses related to facilities lease cancellations and write-downof assets no longer in use. During 2000, the Company paid no cash under therestructuring accrual. Included in accounts payable and accrued expenses atDecember 31, 2000 is approximately $335,000, primarily representing futurelease termination payments.  Alltermination fees were paid in the second quarter of 2001.  The operating activities of the discontinuedoperations were not tracked separately by the Company. During 2002, the Companyrecorded an additional expense of $192,000 to adjust its accrual related to theminimum amount due under a lease for HTR’s Rockville, Maryland facility

 

In December 2001, the employment agreement between theCompany and its Chairman was terminated, resulting in $187,762 of severancerelated expense.

 

F-13

----

 

**9.             LoansReceivable from Related Party**

 

Loans receivable from a Company officer amounted to$140,183 and $116,753 as of December 31, 2001 and 2002, respectively. TheCompany accrues interest on the loans receivable at a rate of prime less1%.  Interest income related to loansreceivable amounted to  $8,000, $8,001and $6,384 during the years ended December 31, 2000, 2001 and 2002, respectively.  Amounts repaid on loans receivable fromrelated parties was $23,097 in 2002. No amounts were repaid on loans receivablefrom related parties in 2000 or 2001.

 

**10.          NotesPayable**

 

In June 1999, the Company raised $2.5 million throughthe issuance of 9% Secured Subordinated Convertible Debentures.  The debentures were due to mature onDecember 15, 2000 with accrued interest payable quarterly.  The debentures were convertible into sharesof the Company’s common stock at a per share price of $55.50.  The conversion price was at a discount fromthe market value of the Company’s common stock on the date the debentures wereissued.  In addition, the Company issuedfive-year warrants to the debenture holders for the purchase of 11,260 sharesof the Company’s common stock at $63.80 per share.  The Company recorded an aggregate debt discount of approximately$413,000 for the value of the warrants and the ability to convert at a discountfrom market value. Throughout 1999 and 2000 all of the debentures wereconverted into shares of common stock. See Note 13.  In the fourthquarter of 2000, the Company recalculated the debt discount related to thedebentures under the guidance provided in EITF 00-27 and recorded a cumulativeeffect of change in accounting principle of $461,000.

 

In February 2001, the Company secured $1,150,000 ofdebt financing through the issuance of short-term notes bearing interest at 10%to two directors of the Company.  Inconnection with this financing, the Company granted stock options for thepurchase of 5,750 shares of common stock at $9.38 per share to thedirectors.  The fair value of theoptions was estimated at $47,150 using the Black-Scholes option pricing modeland has been included in stock-based compensation in the 2001 consolidatedstatement of operations.  These noteswere cancelled in March 2001 in exchange for an aggregate of 118,378 shares ofcommon stock at a purchase price of $9.78 per share and warrants to purchase anaggregate of 28,750 shares of common stock at an exercise price of $10.76 pershare.  The warrants have a three yearterm and were fully vested upon issuance. The fair value of the warrants was estimated at $212,750 using theBlack-Scholes option pricing model and has been included in stock-basedcompensation in the 2001 consolidated statements of operations.

 

In December 2001 and January 2002, the Company raised$925,000 through the issuance of 8% debentures together with five-year, fullyvested warrants to purchase 132,143 shares of common stock at $4.00 pershare.  The Company allocated theproceeds of the offering to the debentures and the warrants based on theirrelative fair values using the Black-Scholes option pricing model.  The amount allocated to the warrants($335,841 and $40,708 for the 2001 and 2002 funding, respectively), wasrecorded as a debt discount and is being amortized to interest expense over theperiod the debentures are expected to be outstanding.  In March 2002, the Companyissued 1,458,413 shares of Series F-1 Preferred Stock and five-year fullyvested warrants to purchase 14,584 shares of common stock at $4.00 per share inexchange for the cancellation of a note in the original principal amount of$500,000 plus $10,445 in accrued interest. In May 2002, the Company issued of 5,878 shares of Series F-2Preferred Stock plus a warrant to purchase 5,878 shares of common stock at$4.00 per share, in exchange for the cancellation of a convertible promissorynote in the principal and accrued interest amount of $205,730.  Upon shareholder approval of the debtfinancing, the Company recorded an additional $91,563 of debt discount for theinstruments’ beneficial conversion feature. The unamortized debt discount at December 31, 2002 was $84,841.  Principal and accrued interest under thedebentures are due and payable at December 31, 2003.  The debentures are convertible into shares of the Company’scommon stock at the election of the holders at a conversion price of $3.50 pershare.

 

**11.          Commitmentsand Contingencies**

 

#### *Leases*

 

The Company leases office space and officeequipment  under non-cancelableoperating lease agreements with various renewal options. Future minimum leasepayments may be periodically adjusted based on changes in the lessors’operating charges.  Rent expense for theyears ended December 31, 2000, 2001 and 2002 was  $792,459, $486,479 and $521,953 respectively.  As of December 31, 2002, the Company isobligated under an operating lease for space vacated as part of the 2000restructuring.  The monthly payment forthis space is approximately $13,000. The Company is currently negotiating a termination of the lease but hasaccrued the minimum amount that would be due under the lease.  Subsequent to year end, the Company wasordered to pay all outstanding amounts related to this vacated space.  The Company is contesting the liability forfuture rents beyond December 2003 per the lease terms. Further litigation isanticipated.  See Note 17.

 

F-14

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As of December 31, 2002, payments due undernon-cancelable operating leases were as follows:

 
| 2003       |   | $         | 656,096   |   |
|------------|--------|-----------|-----------|--------|
| 2004       |   | 509,735   |      |
| 2005       |   | 525,027   |      |
| 2006       |   | 540,778   |      |
| 2007       |   | 557,001   |      |
| Thereafter |   | 1,263,601 |      |
|       |   | $         | 4,052,238 |   |

 

The Company also leases equipment under leaseagreements which are capitalized using the interest rates appropriate at theinception of the lease.  The relatedequipment is included in property and equipment and depreciatedaccordingly.  Future minimum leasepayments under capital lease obligations at December 31, 2002 are as follows:

 
| 2003                                   |   | 24,800 |   |
|----------------------------------------|--------|--------|--------|
| Less  amounts representing interest    |   | (1,271 | )      |
| Present  value of net minimum payments |   | 23,529 |   |

 

*Employment Agreements*

 

The Company has entered into employment agreementswith certain members of management and other key employees.  These agreements specify minimum annualsalaries as well as discretionary bonus amounts to be paid over the next twoyears.

 

#### *PurchaseCommitment*

 

Effective December 15, 2000 the Company entered into athree-year reseller agreement with a vendor to resell certain software.  The agreement, as amended, specifies aminimum contract commitment of $650,000 over the three year period.   Amounts paid under the agreement during theyears ended December 31, 2001 and 2002 were $143,000 and $144,697,respectively. No amounts were paid under the agreement in 2000.

 

*Litigation*

 

The Virginia Department of Taxation recently completedan audit of VCampus’ sales and use tax payments from August 1998 throughOctober 2001.  In July 2002, the Companyreceived a draft assessment which contemplated a payment of taxes, penalties andinterest by VCampus of $212,719 primarily associated with the alleged failureof VCampus to assess use tax on third-party royalties paid by VCampus tocontent providers for courses delivered online by the Company. This preliminaryassessment was not yet a formal, binding assessment by the Virginia Departmentof Taxation. The Company paid the sales and use tax, and interest onnon-contested items, which amounted to $18,928 out of the $212,719,respectively. The Company has formally contested the remaining items covered bythe draft assessment, including the assessment of use tax on the royalties paidby VCampus to content providers for courses delivered online by the Company.The Company is also contesting the methodology used by the Virginia Departmentof Taxation to estimate the royalties. The Company does not have a firmestimate of the probability of liability for this issue or the amount ofanticipated legal costs, but has reason to believe that the potential liabilitywill be reduced to the point where it will not be considered material. Accordingly,the Company cannot estimate at this time the amount of the liability to beincurred, if any. No amounts have been accrued in the financial statements forthis potential liability.

 

On June 26, 2002, a former employee (separated in June1998) filed suit against the Company in Dallas County, Texas. The suit allegesdamages in the following amounts: $56,250 from an allegedly earned unpaidbonus, $231,250 based on an alleged change of control in the Company and$360,000 for the company’s alleged failure to allow him to exercise stockoptions. After thorough investigations, the Company has rejected this formeremployee’s claims several times in the past and the Company continues tobelieve these claims are without merit and plans to vigorously defend againstthem. The case was subject to mediation in December 2002, which failed toproduce a settlement. The case is scheduled for trial in September 2003.  The plaintiff filed a motion for summaryjudgment on the issue of the unpaid bonus, which is expected to be heardshortly. The Company at this time cannot provide a definitive estimate of legalfees required for the case; however they may become material as the caseprogresses. The Company cannot estimate at this time the amount or probabilityof the liability to be incurred, if any. Accordingly, no amounts have beenaccrued in the financial statements.

 

F-15

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**12.          AccruedExpenses**

 

Accrued expenses consisted of the following:

 

|                                            |   | **December  31,** |      |
|-------------------------------------------------|--------|-------------------|-----------|
|                                            |   | **2001**          |      | **2002** |   |
| Accrued  royalties                              |   | $                 | 226,577   |   | $ | 230,679 |   |
| Accrued  payroll and payroll taxes              |   | 91,413            |      | 62,333 |   |
| Accrued  reorganization and non recurring costs |   | 187,762           |      | 276,103 |   |
| Accrued  vacation                               |   | 55,477            |      | 41,063 |   |
| Other                                           |   | 641,874           |      | 217,682 |   |
|                                            |   | $                 | 1,203,103 |   | $ | 827,860 |   |

 

Accrued payroll as of December 31, 2001 and 2002primarily consists of earned but unpaid commissions and bonuses.

 

Accrued reorganization and non recurring costs as ofDecember 31, 2001 primarily consist of severance related expense in connectionwith the termination of the employment agreement between the Company and itschairman.

 

Accrued reorganization and non recurring costs as ofDecember 31, 2002 primarily consist of an accrual in connection with the minimum payment due under a lease forHTR’s Rockville, Maryland lease.   SeeNotes 7, 8 and 17.

 

**13.          Stockholders’Equity**

 

# ***Stock Split***

 

On June 18, 2002, the Company’s Board of Directorsapproved a one-for-ten reverse stock split of the Company’s common stock.  The reverse stock split became effective asof the opening of business on July 8, 2002. Stockholders’ equity has been restated to give retroactive recognitionto the stock split for all periods presented by reclassifying the excess parvalue resulting from the reduced aggregate number of shares from common stockto paid-in capital.  All references tocommon shares and per share amounts for all periods presented have beenretroactively restated to reflect the stock split.

 

*Series C Preferred Stock*

 

In March 1998, the Company raised net proceeds ofapproximately $5,300,000 in a private placement of Series C Preferred Stock andwarrants (the “Series C Preferred Stock”). In this transaction, the Companyissued approximately 626,300 shares of the Series C Preferred Stock, which areconvertible into approximately 75,910 shares of common stock. The Company alsoissued five-year warrants, which were fully vested, to purchase approximately62,630 shares of common stock at an exercise price of $84.60 per share.  The Series C Preferred stockholders areentitled to receive dividends if and when declared by the Board ofDirectors.  The Series C Preferred Stockhas a liquidation preference of $12.69 per share plus all declared but unpaiddividends upon sale or liquidation of the Company. The common stock underlyingboth the Preferred Stock and the warrants has certain registration rights. Theholders of the Series C Preferred Stock are entitled to one vote for each 10shares of Series C Preferred Stock held. The Company recorded deemed dividends of approximately $207,000 due tothe Series C Preferred Stock being convertible to common stock at a discountfrom fair value on the date of issuance. In 1999, 2,954 shares of Series C Preferred Stock were converted into358 shares of common stock.

 

*SeriesD Preferred Stock*

 

In June 1998, the Company raised approximately$5,200,000 in net proceeds through its private placement of Series D PreferredStock (the “Series D Preferred Stock”). In this transaction, the Company issued1,082,625 shares of the Series D Preferred Stock, which are convertible to108,263 common shares. The holders of Series D Preferred Stock are entitled toreceive a 5% annual dividend compounded and paid semi-annually. Such dividendsare payable, at the option of the Company, either in cash or in common stock.The Series D Preferred Stock has a liquidation preference of $8.25 per shareplus all declared but unpaid dividends upon sale or liquidation of theCompany.   The holders of the Series DPreferred Stock are entitled to one vote for each 10 shares of Series DPreferred Stock held.

 

In  2000 and2001, 2,727 and 56,834 shares of Series D Preferred Stock were converted into273 and 5,683 shares of common stock, respectively.  No shares were converted during 2002.

 

In 2000, 2001 and 2002, the Company issued 24,507,49,461 and  81,325 shares of commonstock, respectively, to the Series D Preferred Stock holders as payment foraccrued dividends.  The number of sharesissued as payment of the dividends was determined based on the fair marketvalue of the Company’s common stock on the date of issuance.  The value of such shares amounted to,$295,607, $278,798 and $278,765 for 2000, 2001 and 2002, respectively.

 

 

F-16

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*SeriesE Preferred Stock*

 

The Company entered into a Private Equity Line ofCredit Agreement (the “Equity Line Agreement”), as amended, with Hambrecht& Quist Guaranty Finance, LLC (“H&QGF”) effective May 4, 1999. Underthe Equity Line Agreement, the Company had the right, subject to certain conditions,to issue and sell to H&QGF, from time to time, shares of its Series EConvertible Preferred Stock (“Series E Preferred Stock”), for cashconsideration of up to an aggregate of $7.0 million, subject to availability.  The Company had the right to sell toH&QGF shares of its Series E Preferred Stock at a price equal to 85% of thelower of (1) the closing market price of the Company’s common stock on the dateof issuance and (2) the average of the lowest intra-day prices of the Company’scommon stock over the five-day period ending on the date of issuance.  Each ten shares of Series E Preferred Stockare convertible into one share of common stock.  The holders of the Series E Preferred Stock are entitled to onevote for each ten shares of Series E Preferred Stock held.  The holders of Series E Preferred Stock areentitled to monthly dividends paid in Series E Preferred Stock, equal to 0.5%of the number of shares of Series E Preferred Stock held.  The value of Series E Preferred Stock issuedas dividends amounted to $83,977, $107,733 and $10,954 for 2000, 2001 and 2002,respectively.

 

In connection with the Equity Line Agreement, theCompany issued seven-year warrants, which were fully vested, to purchase100,000 shares of its Series E Preferred Stock to H&QGF at $2.50 per share(subsequently adjusted to 1,138,440 shares at $0.2196 per share pursuant toanti-dilution rights), and ten-year warrants, which were fully vested, topurchase 10,000 shares of its common stock at $40.00 per share to a third party.  In March 2000, the Company granted H&QGFfully vested warrants to purchase 43,632 shares of Series E Preferred Stock atan exercise price of $8.50 per share (subsequently adjusted to 384,960 sharesat $0.2196 per share pursuant to anti-dilution rights) in exchange for anincrease in capacity and extension of the equity line.  These warrants expire in November 2006.  In October 2000, the Company grantedH&QGF fully vested, seven-year warrants to purchase 15,000 shares of SeriesE Preferred Stock at an exercise price of $1.94 per share (subsequentlyadjusted to 132,350 shares at $0.2196 per share pursuant to anti-dilutionrights) in exchange for a further increase and extension of the equity line.

 

During 1999, the Company drew down $859,000 under theEquity Line Agreement and issued 379,437 shares of Series E Preferred Stock atan average price of $2.26.  During 2000,the Company drew down $4,382,000 under the Equity Line Agreement and issued963,092 shares of Series E Preferred Stock at an average price of $4.55 pershare.  During 2001, the Company drewdown $213,150 under the Equity Line Agreement and issued 187,500 shares ofSeries E Preferred Stock at an average price of $1.14 per share.  During 2000 and 2001, 621,503 and 306,454shares of Series E Preferred Stock were converted into 62,150 and 30,645 commonshares, respectively. No shares of Series E Preferred Stock were converted intocommon stock in 2002.

 

During 2000 and 2001, the Company recorded deemeddividends of approximately $773,000 and $38,000, respectively, due to theSeries E Preferred Stock being issued at a discount from fair value on the dateof issuance.  No deemed dividends wererecorded in 2002.

 

In February 2001, the Equity Line Agreement wasterminated.  During 2001, the Companyissued 60,000 shares of Series E Preferred Stock to H&QGF as considerationfor the Company’s failure to keep an active registration statement effective inaccordance with H&QGF’s registration rights.  In April 2001, the Company regained compliance with H&QGF’sregistration rights through the filing and effectiveness of a new registrationstatement.

 

*SeriesF, F-1 and F-2 Preferred Stock*

 

In December 2001, the Company issued 2,642,836 sharesof Series F Preferred Stock at a price of $0.35 per share.  Under the terms of this financing, theCompany issued five-year fully vested warrants to purchase 66,071 shares ofcommon stock at $4.00 per share.  As ofDecember 31, 2001, 285,712 shares of Series F Preferred Stock were subscribedfor but not issued until January 2002.  Each share of Series F-1 Preferred Stock was initially convertible into 1/10thof a share of common stock at any time at the election of the holder.  The Series F preferred stockholdersare entitled to receive dividends if and when declared by the Board ofDirectors.  The Series F Preferred Stockhas a liquidation preference of $0.35 per share plus all declared but unpaiddividends upon sale or liquidation of the Company.  The holders of the Series F Preferred Stock are entitled to onevote for each ten shares of Series F Preferred Stock held.

 

The Company allocated the proceeds from the Series FPreferred Stock offering between the preferred stock and warrants on a relativefair value basis.  The fair value of thewarrants was estimated using the Black-Scholes option pricing model.  The proceeds 

 

F-17

----

 

allocated to the preferred stock were $700,000.  The excess of the value of the common stockinto which the Series F Preferred Stock was convertible on the date of issuanceover the proceeds allocated to the preferred stock amounted to $225,000.  This amount represents the beneficialconversion feature discount on the Series F Preferred Stock and has beenreflected as a deemed dividend in the 2001 statement of operations.  This discount was recognized entirely in2001 as the Series F Preferred Stock is immediately convertible.

 

In March 2002, the Companyissued 1,458,413 shares of Series F-1 Preferred Stock and five-year fullyvested warrants to purchase 14,584 shares of common stock at $4.00 per share inexchange for the cancellation of a note in the original principal amount of$500,000 plus $10,445 in accrued interest. Each share of Series F-1Preferred Stock was initially convertible into 1/10th of a share ofcommon stock at any time at the election of the holder.  The holders of the Series F-1Preferred Stock are entitled to one vote for each ten shares of Series F-1Preferred Stock held.  The excess of the fair value of the PreferredStock and warrants over the carrying value of the note amounted to $267,488 andwas recognized as a loss on debt extinguishment in March 2002.  The carrying value of the debt at thetime of its conversion was $324,392, excluding accrued interest of$10,445.  The extinguishment of the debtresulted in the write-off of $50,121 in deferred debt issuance costs.  The excess of the value of common stock intowhich the Series F Preferred Stock is convertible over the amount allocated tothe Preferred Stock amounted to $44,282. Such amount represented a beneficial conversion feature discount and wasrecognized as a deemed dividend to the preferred stockholder upon stockholderapproval of the transaction in May 2002.

 

In May 2002, the Company issued 242,859 shares ofSeries F Preferred Stock for $85,000 in cash at $0.35 per share and warrants topurchase 6,071 shares of common stock at $4.00 per share.  Each share of Series F Preferred Stock was initially convertible into 1/10thof a share of common stock at any time at the election of the holder.  The proceeds were allocated to thePreferred Stock and the warrants based on their relative fair values.  The excess of the value of common stock intowhich the Series F Preferred Stock is convertible over the proceeds allocatedto the Preferred Stock amounted to $57,104. Such amount represented a beneficial conversion feature discount and wasrecognized as a deemed dividend to preferred stockholders upon stockholderapproval of the offering in May 2002.

 

In May 2002, the Company issued 17,859 shares ofSeries F-2 Preferred Stock for approximately $625,000 in cash at $35.00 pershare (each of which Series F-2 Preferred Share was initially convertible into10 shares of common stock) and warrants to purchase a total of 160,365 sharesof common stock at $4.00 per share.  Theholders of Series F-2 Preferred Stock are entitled to one vote for each shareof common stock that such holder could have purchased at the fair market valueof the Common Stock on the date the Series F-2 Preferred Stock was originallypurchased from the Company for the aggregate purchase price paid for the SeriesF-2 Preferred Stock   The proceeds wereallocated to the Preferred Stock and the warrants based on their relative fairvalues.  The excess of the value ofcommon stock into which the Series F-2 Preferred Stock is convertible over theproceeds allocated to the Preferred Stock amounted to $579,746.  Such amount represented a beneficialconversion feature discount and was recognized as a deemed dividend topreferred stockholders upon stockholder approval of the offering in May 2002.

 

In May 2002, the Company issued 5,878 shares of SeriesF-2 Preferred Stock plus a warrant to purchase 5,878 shares of common stock at$4.00 per share, in exchange for the cancellation of a convertible promissorynote in the principal and accrued interest amount of $205,730, each of whichSeries F-2 Preferred Share was initially convertible into 10 shares of commonstock. The excess of the fair value of the Preferred Stock and warrants overthe net carrying value of the debt was $170,677 and was recognized as a loss ondebt extinguishment.  The carrying valueof the debt at the time of its conversion was $143,944, excluding accruedinterest of $5,730.  The extinguishmentof the debt resulted in the write-off of $16,038 in deferred debt issuancecosts.  The excess of the value ofcommon stock into which the Series F Preferred Stock is convertible over theamount allocated to the Preferred Stock amounted to $24,267.  Such amount represented a beneficialconversion feature discount and was recognized as a deemed dividend to thepreferred stockholder upon stockholder approval of the transaction in May 2002.

 

In May 2002, the Company issued 3,841 shares of SeriesF-2 Preferred Stock in exchange for the cancellation of $126,970 of accountspayable, each of which Series F-2 Preferred Share was initially convertibleinto 10 shares of common stock.  Theexcess of the fair value of the Preferred Stock over the carrying value of theaccounts payable amounting to $65,081 was recognized as a loss on theexchange.  The excess of the value ofcommon stock into which the Series F Preferred Stock is convertible over theamount allocated to the Preferred Stock amounted to $57,627.  Such amount represented a beneficial conversionfeature discount and was recognized as a deemed dividend to the preferredstockholder upon stockholder approval of the transaction in May 2002.

 

In June 2002, the Company issued 114,305 shares ofSeries F Preferred Stock for $40,007 in cash at $0.35 per share and warrants topurchase 2,858 shares of common stock at $4.00 per share.  Each share of Series F Preferred Stock wasinitially convertible into 1/10th of a share of common stock at any time at theelection of the holder.  The proceedswere allocated to the Preferred Stock and the warrants based on their relativefair values.  The excess of the value ofcommon stock into which the Series F Preferred Stock is convertible over theproceeds allocated to the Preferred Stock amounted to $17,685.  Such amount represented a beneficialconversion feature discount and was recognized as a deemed dividend topreferred stockholders upon stockholder approval of the offering in May 2002.

 

 

F-18

----

 

 

*SeriesG Preferred Stock*

 

In September 2002, the Companyissued 46,400 shares of Series G Preferred Stock at a purchase price of $21.96per share (10 times the trailing five-day average closing price of itscommon stock) to accredited investors. Under the terms of the financing agreement, the Company also issued five-year fully vested warrants to purchase116,000 shares of common stock at $2.42 per share.  Each share of Series GPreferred Stock is initially convertible into 10 shares of common stock at anytime at the election of the holder.  Theholders of the Series G Preferred Stock are entitled to ten votes for share ofSeries of Preferred Stock held.  Theexcess of the value of common stock into which the Series G Preferred Stock isconvertible over the proceeds allocated to the Preferred Stock amounted to$185,883.  Such amount represented abeneficial conversion feature discount and was immediately recognized as adeemed dividend to preferred stockholders. The issuance of the Series G Preferred Stock triggered an antidilutionadjustment in the conversion price of the Series F, F-1 and F-2 Preferred Stockfrom $3.50 to $2.196.  As result, thenumber of common shares potentially issuable upon conversion of the Series F,F-1 and F-2 Preferred Stock has increased from 721,620 to 1,150,124.  The Company recorded a deemed dividend of$1,499,762 in connection with this adjustment.

 

InNovember 2002, the Company issued2,800 and 120 shares of Series G Preferred Stock at a purchase price of $24.90per share (10 times the trailing five-day average closing price of itscommon stock) to accredited investors and a placement agent, respectively.  Under the terms of this financing, theCompany also issued five-year fully vestedwarrants to purchase 7,000 and 300 shares of common stock at $2.74 per share tothe same accredited investors and placement agent, respectively.  Each share of Series G Preferred Stock is initially convertible into 10 shares ofcommon stock at any time at the election of the holder.  The excess of the value of commonstock into which the Series G Preferred Stock is convertible over the proceedsallocated to the Preferred Stock amounted to $12,283.  Such amount represented a beneficial conversion feature discountand was immediately recognized as a deemed dividend to preferred stockholders.

 

*CommonStock*

 

In January 2000, the Company completed a privateplacement of its Common Stock to iGate Capital Corporation (formerly MastechCorporation). The Company issued 113,625 shares of Common Stock at $36.20 pershare, a 20% premium over the average closing price for a 15-day trailingperiod, resulting in gross proceeds to VCampus of approximately$4,000,000.  No obligations with respectto the delivery of goods or the performance of services were involved indetermining this purchase price.  TheCompany also issued warrants, which were fully vested, to purchase 45,000shares of its common stock at exercise prices between $43.40 and $61.25 pershare. The warrants expired in January 2001.

 

During 2000, the Company issued 48,257 shares of itscommon stock to its convertible debenture holders, at an average price of$33.00 per share, in exchange for the conversion of the remaining balance ofapproximately $1,590,000 in principal and accrued interest under the SecuredSubordinated Convertible Debentures.

 

In April 2000, the Company raised $2,500,000 through aprivate placement of its common stock to US West Internet Ventures, Inc, nowQwest Investment Company.  The Companyissued 35,714 shares of common stock at $70.00 per share and five-year warrantsto purchase 71,429 shares of the Company’s common stock at $70.00 pershare.  One-half of the warrants vestedimmediately with the second half vesting on the first anniversary of theissuance of the warrants.  Also in April2000, the Company entered into a one-year Application Hosting Contract with USWest Interprise America, Inc. (US West) under which US West may resell certainVCampus services.  The Company hasvalued the second tranche of the warrants using the Black-Scholes option  pricing model at each reporting date priorto the commitment date.  The fair valueof the warrants at December 31, 2000 was $207,142.  Of that amount, $144,716 was recognized as stock basedcompensation for the year ended December 31, 2000.   The fair value of the warrant at the commitment date in April2001 was $310,714.  Of that amount,$165,998 was recognized as stock based compensation for the year ended December31, 2001.

 

In September 2000, the Company granted 2,000 shares ofrestricted stock with a purchase price of $0.10 per share to an employee ithired as an officer and a director.  Anadditional 500 options were granted with an exercise price equal to 50% of thefair market value at the date of grant to the same employee.  The Company recorded compensation expense,under APB 25, related to these stock issuances of approximately $184,000.

 

F-19

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In December 2000, the Company sold 51,948 shares ofits common stock at $9.625 per share to accredited investors.  The purchase price of $9.625 equaled 110% ofthe fair market value of the stock on the date of the transaction.  In connection with this transaction, theCompany also issued fully vested 5-year warrants to purchase 51,948 shares ofthe Company’s common stock at $9.625 per share.  No obligations with respect to the delivery of goods or theperformance of services were involved in determining this purchase price.

 

In December 2000, the Company issued 16,706 shares ofits common stock at $9.625 per share to certain employees, executive officers,and directors.  The purchase price of$9.625 equaled 110% of the fair market value of the stock on the date of thetransaction.  In connection with thistransaction, the Company also issued fully vested 5-year stock options topurchase 16,706 shares of the Company’s common stock at $9.625 per share.

 

In December 2000, the Company issued 4,000 shares ofits common stock to a financial advisor as a retainer fee.   The stock was valued at the then fairmarket value of $8.125 per share.  TheCompany recorded an expense related to the stock issuance of $32,500.

 

In May and June 2001, the Company issued 303,892shares of common stock at a purchase price of $10.60 per share in a privateplacement.  Under the terms of thisfinancing, the Company also issued five-year, fully vested warrants to purchase93,848 shares of common stock at $17.90 per share.

 

During 2002, the Company issued 10,794 shares of itscommon stock, at an average price of $3.15 (equal to the fair market value ofthe stock on date of each transaction) per share, to certain of its directorsin lieu of cash compensation for their services.  The Company recorded $33,972 of compensation expense inconnection with these issuances.

 

*Stock Option Plans*

 

The Company adopted a stock option plan (the “OriginalPlan”) which permitted the Company to grant options to purchase up to 28,892shares of Common Stock to employees, board members and others who contributematerially to the success of the Company. In November 1996, the Company’s Boardof Directors decided not to grant any further options under the Original Plan.

 

During 1996, the Company’s Board of Directors approveda new stock plan (the “1996 Plan”), for the grant of stock awards to employees,directors and consultants.  Stockoptions under the Original Plan and 1996 Plan are generally granted at priceswhich the Company’s Board of Directors believes approximates the fair marketvalue of its Common Stock at the date of grant. Individual grants generallybecome exercisable ratably over a period of four to five years from the date ofgrant. The contractual terms of the options range from three to ten years fromthe date of grant.

 

Common stock option activity was as follows:

 
|                                      |   | **Years  Ended December 31,** |   |
|-------------------------------------------|--------|-------------------------------|--------|
|                                      |   | **2000**                      |   | **2001** |   | **2002** |   |
|                                      |   | **Shares**                    |   | **Weighted  Average  Exercise  Price** |   | **Shares** |   | **Weighted  Average  Exercise  Price** |   | **Shares** |   | **Weighted  Average  Exercise  Price** |   |
| Outstanding  at the beginning of the Year |   | 140,814                       |   | $ | 97.90 |   | 245,964 |   | $ | 71.40 |   | 325,637 |   | $ | 18.95 |   |
| Granted                                   |   | 229,324                       |   | 62.80 |   | 302,741 |   | 6.50 |   | 111,222 |   | 3.71 |   |
| Exercised                                 |   | (35,770                       | )      | 20.40 |   | (85 | ) | 0.10 |   | (25,576 | ) | 3.36 |   |
| Canceled  or expired                      |   | (88,404                       | )      | 112.10 |   | (222,983 | ) | 60.00 |   | (111,418 | ) | 17.87 |   |
| Outstanding  at the end of the Year       |   | 245,964                       |   | 71.40 |   | 325,637 |   | 18.95 |   | 299,865 |   | 15.03 |   |
| Options  exercisable at year-end          |   | 59,724                        |   | $ | 69.40 |   | 140,739 |   | $ | 19.50 |   | 198,829 |   | $ | 13.06 |   |

 

As of December 31, 2002, 143,453 shares were availablefor issuance under the 1996 Plan.

 

F-20

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The following table summarizes information aboutfixed-price stock options outstanding at December 31, 2002:

 

|                                           |   | **Options  Outstanding**                       |   | **Options  Exercisable**                  |   |
|------------------------------------------------|--------|------------------------------------------------|--------|-------------------------------------------|--------|
| **Range of  Exercise Prices**                  |   | **Number  Outstanding at  December 31,  2002** |   | **Average  Remaining  Contractual  Life** |   | **Weighted-  Average  Exercise  Price** |   | **Number  Exercisable at  December 31,  2002** |   | **Weighted-  Average  Exercise  Price** |   |
| Less  than     $10.00      |   | 226,030                                        |   | 8.7                                       |   | $ | 3.54 |   | 154,342 |   | $ | 3.52 |   |
| $   10.00 –    $30.00 |   | 24,027                                         |   | 7.9                                       |   | 13.55 |   | 14,394 |   | 13.51 |   |
| $   30.01 –    $60.00 |   | 22,120                                         |   | 6.5                                       |   | 40.76 |   | 19,120 |   | 40.16 |   |
| $   60.01 –    $90.00 |   | 20,241                                         |   | 7.5                                       |   | 76.64 |   | 5,154 |   | 76.67 |   |
| $   90.01 – $120.00             |   | 4,745                                          |   | 5.1                                       |   | 110.73 |   | 3,695 |   | 110.22 |   |
| $  120.01 – $150.00                       |   | 2,452                                          |   | 5.7                                       |   | 138.21 |   | 1,874 |   | 135.52 |   |
| $  150.01 – $180.00                       |   | 250                                            |   | 4.7                                       |   | 176.20 |   | 250 |   | 176.20 |   |
|                                           |   | 299,865                                        |   | 8.3                                       |   | $ | 15.03 |   | 198,829 |   | 13.06 |   |
|                                                |        |                                                |        |                                           |        |  |  |  |  |  |  |  |  |

 

The weighted average fair values of the optionsgranted in 2000 with a stock price equal to the exercise price, and with astock price greater than the exercise price, and with a stock price less thanthe exercise price are $7.80, $72.70 and $9.60, respectively.  The weighted average fair values of theoptions granted in 2001 with a stock price equal to the exercise price was$6.50.   The weighted average fairvalues of the options granted in 2002 with a stock price equal to the exerciseprice was $3.71.

 

On June 15, 2001, the Company cancelled options topurchase 81,038 shares of common stock and agreed to issue an equal number ofnew options on December 17, 2001 with an exercise price equal to thethen-current fair market value.  Theemployees whose options were cancelled had not received options in the sixmonths prior to the cancellation date. On December 17, 2001, the Company issued 73,803 replacement options toemployees who participated in the exchange program, with an exercise priceequal to the fair market value on that date.

 

*Warrants*

 

The Company has also granted warrants to purchaseCommon Stock to various investors, employees and outside vendors. Warrantactivity was as follows:

 

|                                      |   | **Years  Ended December 31,** |   |
|-------------------------------------------|--------|-------------------------------|--------|
|                                      |   | **2000**                      |   | **2001** |   | **2002** |   |
| Outstanding  at the beginning of the year |   | 197,149                       |   | 377,414 |   | 635,388 |   |
| Granted                                   |   | 197,729                       |   | 389,630 |   | 551,492 |   |
| Exercised                                 |   | (11,649                       | )      | — |   | — |   |
| Canceled  or expired                      |   | (5,815                        | )      | (131,656 | ) | (77,969 | ) |
| Outstanding  at the end of the year       |   | 377,414                       |   | 635,388 |   | 1,108,911 |   |

 

Exercise prices on the outstanding warrants range from$2.20 to $120.00 per share. The weighted average grant date fair value ofwarrants issued in 2002 was $4.80.  Thefair value of each warrant grant is estimated on the date of grant using theBlack-Scholes option-pricing fair value model with the following ranges ofassumptions: dividend yield of 0%; expected volatility of 69% to 133%;risk-free interest rate of 4.39% to 6.50%; and expected life of the warrantterm of three to seven years.  During2000, 2001 and 2002, the number of shares and exercise prices of certainwarrants were adjusted to satisfy certain anti-dilution rights previouslygranted.

 

*Reserve for Issuance*

 

As of December 31, 2001, the Company had reserved1,408,776 shares of Common Stock for issuance upon the exercise of outstandingoptions and warrants.

 

**14.          RetirementPlans**

 

The VCampus Corporation 401(k) plan (adopted in 1997)allows employees to elect an amount between 1% and 15% of their totalcompensation to contribute to the plan. All full-time employees are eligible tomake participation elections at any time while employed by the Company. Thereis a graduated vesting schedule for employer contributions in whichcontributions fully vest over a period of four years. The plan allowsdiscretionary Company contributions. In 2000, 2001 and 2002, there were nodiscretionary Company contributions made to the plan.

 

F-21

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**15.          IncomeTaxes**

 

Deferred income taxes reflect the net tax effects oftemporary differences between the carrying amounts of assets and liabilitiesfor financial reporting and income tax purposes. The Company has recognized afull valuation allowance against the deferred tax assets because it is morelikely than not that sufficient taxable income will not be generated during thecarryforward period available under the tax law to utilize the deferred taxassets.  Significant components of theCompany’s net deferred tax assets were as follows:

 

|                               |   | **December  31,** |       |
|------------------------------------|--------|-------------------|------------|
|                               |   | **2001**          |       | **2002** |   |
| Net  operating loss carryforwards  |   | $                 | 21,314,000 |   | $ | 22,647,000 |   |
| Accrued  payroll                   |   | 53,000            |       | 16,000 |   |
| Other  accruals                    |   | 70,000            |       | 285,000 |   |
| Other  assets and liabilities, net |   | 1,662,000         |       | 1,722,000 |   |
| Total  deferred tax assets         |   | 23,099,000        |       | 24,670,000 |   |
| Valuation  allowance               |   | (23,099,000       | )          | (24,670,000 | ) |
| Net  deferred tax assets           |   | $                 | —     |   | $ | — |   |

 

As of December 31, 2001and 2002, the Company had netoperating loss carryforwards for federal income tax purposes of approximately$53,278,000 and $56,610,000, respectively, which will expire at various datesthrough 2022. The Company may have had changes in ownership, which may imposelimitations on its ability to utilize net operating loss carryforwards underSection 382 of the Internal Revenue Code.

 

The Company’s effective rate reconciling items relateto non-deductible expenses, state income taxes, and changes to the valuationallowance.

 

**16.          Net LossPer Share**

 

The following table sets forth the computation ofbasic and diluted net loss per share:

 

|                                                                                |   | **Years  Ended December 31,** |        |
|-------------------------------------------------------------------------------------|--------|-------------------------------|-------------|
|                                                                                |   | **2000**                      |        | **2001** |   | **2002** |   |
| Numerator:                                                                          |   |                          |        |   |   |   |   |
| Loss  before cumulative effect of change in accounting principle                    |   | $                             | (12,423,745 | ) | $ | (5,932,893 | ) | $ | (4,378,911 | ) |
| Less:  Dividends accruing to preferred stockholders                                 |   | (1,152,819                    | )           | (649,147 | ) | (2,768,394 | ) |
| Net  loss before cumulative effect of change in accounting principle                |   | (13,576,564                   | )           | (6,582,040 | ) | (7,147,305 | ) |
| Cumulative  effect of change in accounting principle                                |   | (461,000                      | )           | — |   | — |   |
| Net  loss available to common stockholders                                          |   | $                             | (14,037,564 | ) | $ | (6,582,040 | ) | $ | (7,147,305 | ) |
| Denominator:                                                                        |   |                          |        |   |   |   |   |
| Denominator  for basic earnings per share — weighted-average shares            |   | 795,348                       |        | 1,258,610 |   | 1,493,643 |   |
| Denominator  for diluted earnings per share — adjusted weighted-average shares |   | 795,348                       |        | 1,258,610 |   | 1,493,643 |   |
| Basic  and diluted loss per share:                                                  |   |                          |        |   |   |   |   |
| Net  loss per share before cumulative effect of change in accounting principle      |   | $                             | (17.07      | ) | $ | (5.23 | ) | $ | (4.79 | ) |
| Cumulative  effect of change in accounting principle per share                      |   | (0.58                         | )           | — |   | — |   |
| Net  loss per share available to common stockholders                                |   | $                             | (17.65      | ) | $ | (5.23 | ) | $ | (4.79 | ) |

 

F-22

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The following equityinstruments (with underlying common share numbers show in the table) were notincluded in the diluted net loss per share calculation because their effectwould have been anti-dilutive:

 

|                          |   | **Year ended December 31,** |   |
|-------------------------------|--------|-----------------------------|--------|
|                          |   | **2000**                    |   | **2001** |   | **2002** |   |
| Convertible  notes payable:   |   | 4,813                       |   | 49,235 |   | 64,285 |   |
| Convertible  preferred stock: |   |                        |   |   |   |   |   |
| Series  C                     |   | 75,554                      |   | 75,554 |   | 75,554 |   |
| Series D                      |   | 107,337                     |   | 101,380 |   | 101,380 |   |
| Series E                      |   | 28,646                      |   | 54,508 |   | 57,490 |   |
| Series F                      |   | —                      |   | 264,284 |   | 478,142 |   |
| Series F-1                    |   | —                      |   | — |   | 232,443 |   |
| Series F-2                    |   | —                      |   | — |   | 439,540 |   |
| Series G                      |   | —                      |   | — |   | 493,200 |   |
| Stock  options                |   | 245,964                     |   | 325,637 |   | 299,865 |   |
| Warrants                      |   | 377,714                     |   | 635,388 |   | 1,108,911 |   |

 

**17.          SubsequentEvents**

 

#### *Financing*

 

InFebruary 2003, the Company issued10,125 and 226 shares of Series G Preferred Stock at a purchase price of $39.50per share to accredited investors and a placement agent,respectively.  Under the terms of thisfinancing, the Company also issued five-yearfully vested warrants to purchase 25,313 and 564 shares of common stock at$4.35 per share to the same accredited investors and placement agent,respectively.  Each share of Series G Preferred Stock is initiallyconvertible into 10 shares of common stock at any time at the election of theholder.  The excess of the valueof common stock into which the Series G Preferred Stock is convertible over theproceeds allocated to the Preferred Stock amounted to $48,995.  Such amount represented a beneficialconversion feature discount and was immediately recognized as a deemed dividendto preferred stockholders.   These transactionsare reflected in the pro forma balance sheet as if such transactions hadoccurred on December 31, 2002.

 

InMarch 2003, the Company issued18,370 shares of Series G Preferred Stock at a purchase price of $27.22 pershare to accredited investors. Under the terms of this financing, the Company also issued five-year fully vested warrants to purchase 45,925shares of common stock at $2.99 per share to the same accreditedinvestors.  Each share of Series G Preferred Stock is initiallyconvertible into 10 shares of common stock at any time at the election of theholder.  The excess of the valueof common stock into which the Series G Preferred Stock is convertible over theproceeds allocated to the Preferred Stock amounted to $103,186.  Such amount represented a beneficialconversion feature discount and was immediately recognized as a deemed dividendto preferred stockholders.   Thesetransactions are reflected in the pro forma balance sheet as if such transactionshad occurred on December 31, 2002.

 

The following table sets forth selected balance sheetdata as of December 31, 2002, on a pro forma basis, after giving effect to theFebruary 2003 and March 2003 financings.

 

|                             |   | **December  31,  2002** |      | **Pro forma  Adjustments** |   | **Pro forma  as of  December 31,  2002** |   |
|----------------------------------|--------|-------------------------|-----------|----------------------------|--------|------------------------------------------|--------|
|                             |   |                    |      |                       |   | **(Unaudited)**                          |   |
| Cash                             |   | $                       | 727,466   |                       | $      | 899,937                                  |   | $ | 1,627,403 |   |
| Total  assets                    |   | 4,372,618               |      | 899,937                    |   | 5,272,555                                |   |
| Total  liabilities               |   | 2,724,813               |      | 25,000                     |   | 2,749,813                                |   |
| Accumulated  deficit             |   | (84,207,028             | )         | (323,567                   | )      | (84,530,595                              | )      |
| Total  stockholders’ equity |   | $                       | 1,647,805 |                       | $      | 874,937                                  |   | $ | 2,522,742 |   |

#### * *

#### *Legal Matters*

 

In March 2003, the Montgomery County, Maryland CircuitCourt issued an order for VCampus to pay its landlord in Rockville, Maryland$93,453 of back rent due and all future rents ($499,535) less any rentsreceived by the landlord from any re-leasing of the premises. The order callsfor the future rent amount to be paid monthly through the end of the lease termin 2005. The Company plans to contest the liability for future rents beyondDecember 2003 ($323,231) per the lease terms. The liability for back rents andrents through December 2003 and attorney’s fees is reflected on the Company’sbalance sheet. The Company cannot estimate the 

 

F-23

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probability of the liability to be incurred, if any, for rent beyondDecember 2003. Accordingly, no amounts have been accrued in the financialstatements for this.

 

**18.          QuarterlySales and Earnings Data–Unaudited**

 

The following table presentsthe quarterly results for VCampus Corporation and its subsidiaries for theyears ending December 31, 2001 and 2002:

 
|                                          |   | **1st  Quarter** |      | **2nd  Quarter** |   | **3rd  Quarter** |   | **4th  Quarter** |      |
|-----------------------------------------------|--------|------------------|-----------|------------------|--------|------------------|--------|------------------|-----------|
| **2002**                                      |   |             |      |             |   |             |   |             |      |
| Revenue                                       |   | $                | 1,465,701 |             | $      | 1,633,208        |   | $                | 1,735,807 |   | $ | 1,366,958 |   |
| Loss  from operations                         |   | (959,751         | )         | (672,138         | )      | (1,101,971       | )      | (1,343,502       | )         |
| Net  loss attributable to common stockholders |   | (1,511,052       | )         | (1,806,500       | )      | (2,794,858       | )      | (1,034,895       | )         |
| Net  loss per share, basic and diluted        |   | $                | (1.03     | )                | $      | (1.23            | )      | $                | (1.83     | ) | $ | (0.68 | ) |
|                                          |   |             |      |             |   |             |   |             |      |
| **2001**                                      |   |             |      |             |   |             |   |             |      |
| Revenue                                       |   | $                | 1,811,437 |             | $      | 1,969,361        |   | $                | 1,678,833 |   | $ | 1,513,600 |   |
| Loss  from operations                         |   | (2,016,802       | )         | (1,422,166       | )      | (1,191,617       | )      | (1,306,871       | )         |
| Net  loss attributable to common stockholders |   | (2,146,180       | )         | (1,508,617       | )      | (1,272,999       | )      | (1,654,244       | )         |
| Net  loss per share, basic and diluted        |   | $                | (2.20     | )                | $      | (1.26            | )      | $                | (0.89     | ) | $ | (1.16 | ) |

 

F-24

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**SCHEDULE II — VALUATION ANDQUALIFYING ACCOUNT AND RESERVE**

**(in thousands)**

 

**VCampus Corporation**

 
| **Classification**                |   | **Balance at  Beginning of  Period** |   | **Additions** |   | **Deductions** |   | **Balance at  End of Period** |   |
|-----------------------------------|--------|--------------------------------------|--------|---------------|--------|----------------|--------|-------------------------------|--------|
| Allowance  for doubtful accounts: |   |                                 |   |          |   |           |   |                          |   |
| Year  ended December 31, 2000     |   | 142                                  |   | 76            |   | —         |   | 218                           |   |
| Year  ended December 31, 2001     |   | 218                                  |   | 52            |   | (171) (1       | )      | 99                            |   |
| Year  ended December 31, 2002     |   | 99                                   |   | 12            |   | (80) (1        | )      | 31                            |   |

 

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(1)  Uncollectible amounts written off.  Net of recoveries.

 

F-25

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