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

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**FORM 10-K**

**(Mark One)**

| **x** | ** ** | **ANNUAL REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|------------|-----------------------------------------------------------------------------------------------------|

 

**For the fiscal year ended December 31, 2005**

**Commission file number 0-21421**

**VCAMPUS CORPORATION**

**(Exactname of registrant as specified in its charter)**

| **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’stelephone number, including area code: 703-893-7800**

**Securitiesregistered pursuant to Section 12(b) of the Act:**

**None**

**Securities registered pursuant to Section 12(g) ofthe Act:Common Stock ($0.01 par value per share)**

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Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o   No x.

Indicateby check mark if the Registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act. Yes o   No x.

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

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. x

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

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the ExchangeAct. (Check one):

Large AcceleratedFiler o     AcceleratedFiler o     Non-AcceleratedFiler x

Theaggregate market value of the common stock held by non-affiliates of theregistrant based upon the closing price of the common stock of $0.62 per shareon March 20, 2006 on the Nasdaq Capital Market System was approximately$4,817,254 as of such date (and approximately $7,677,712 as of June 30, 2005,the last business day of the registrant’s most recently completed secondquarter). Shares of common stock held by each executive officer and directorand by each person known by the registrant who owns 10% or more of theoutstanding common stock have been excluded in that such persons may be deemedto be affiliates. This determination of affiliate status may not be conclusivefor other purposes.

As of March 20, 2006, theregistrant had outstanding 9,613,502 shares of common stock.

**DOCUMENTS INCORPORATED BY REFERENCE**

Portionsof the Company’s Proxy Statement for the 2006 Annual Meeting of Stockholdersare incorporated herein by reference into Part III of this report.

 

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**NOTE REGARDING FORWARD-LOOKING STATEMENTS**

*Statements in this Annual Reporton Form 10-K that are not descriptions of historical facts areforward-looking statements that are subject to risks and uncertainties. Actualevents or results could differ materially from those currently anticipated dueto a number of factors, including those set forth herein and in VCampus’ otherSEC filings, and including, in particular: continuing losses and negativeoperating cash flows; future capital needs and uncertainty of additionalfunding; intense and increasing competition; dependence on significantcustomers; risks associated with acquisitions, a developing market, rapidtechnological changes and new products; dependence on online distribution;substantial dependence on courseware and third party courseware providers;substantial dependence on third party technology; risks associated withpotential failure to maintain our Nasdaq Capital Market listing and ourdependence on key personnel.*

**PART I**

**Item 1.**                        Business

**Executive Summary**

VCampus Corporation is a provider of comprehensiveoutsourced e-Learning services. We develop courseware and manage and hostInternet-based learning environments that help professional credentialing andcertification organizations, corporations, government agencies and associationsunlock the value of their branded course content. Our services cover a broadrange of e-Learning programs, from registration, enrollment and course deliveryto custom course development, e-commerce and publishing, as well as tracking ofstudents’ progress, reporting of results and production of certificates ofcompletion. VCampus was incorporated in Virginia in July 1984 andreincorporated in Delaware in March 1985.

Through proprietary software, we provide customerswith comprehensive services on an outsourced, or hosted, basis. Our goal is tobe the leading service provider of integrated e-Learning services by helpingcustomers improve their performance and achieve their goals. We believe thatour outsourced hosting approach to web-based e-Learning services providessignificant business advantages to our customers.

Beginning in 2004, we have shifted our emphasis tofocus on our Select Partnerâ program business model and away from ourformer, or Legacy, business model. Under the Select Partner program, we developonline courses for Select Partners that provide professional credentials orcertifications or the training for such credentials and certifications that aredemanded by the markets served by their members or target audiences. We designand build courses based upon each Select Partner’s existing course materialsand/or content, which they have historically delivered or published in atraditional textbook or classroom-based manner, and convert them intointeractive, e-Learning courses. Some of our Select Partners advance funds tocover some or all of the development expenses. For others, we develop thecourses at our expense. In return, each Select Partner generally enters into anexclusive, long-term contract for VCampus to host and deliver the courses tothe Select Partner’s members or target audience. As part of this program, weshare the gross revenue generated from these courses with the Select Partner.

We also maintain customers under our Legacy businessmodel. Under this model, we charge customers a relatively low upfront fee toestablish a customized virtual campus, or “VCampus,” and then charge customerson either a subscription (set fee per period) or usage (charge for actualcourses delivered) basis. We are in the process of transitioning the majorityof our business to the Select Partner model and plan to exit our Legacybusiness model within five years. Approximately 19% of our revenue for the yearended December 31, 2005 was derived from the Select Partner model and 81%from our Legacy business model. We anticipate that the percentage of revenuederived from our Select Partner business model will increase over time as theprogram matures and revenue from Legacy customers stabilizes.

Under the Select Partner model, we target the marketfor professional and technical credentials, certifications and continuingeducation supporting those certifications and credentials. Our primary 

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marketing goals are toidentify and partner with certification and credentialing organizations with: (1) 10,000or more memberships; (2) increasing demand for their subject matter, bodyof knowledge or certification; (3) successful instructor-led educationprograms; and (4) minimal online education presence. We offer theseorganizations the opportunity to grow their revenues by leveraging and scalingtheir existing instructor-led programs through our outsourced e-Learningoffering. Under a typical Select Partner agreement, we enter into an exclusivee-Learning relationship with the partner for three to four years, and wetypically share the revenue from online sales equally with the partner inreturn for our development of the courses from the partner’s content.Historically, there has been no charge to the partner for the coursedevelopment except for the cost of providing subject matter experts to assistin design, development and review of the online course. However, we aretransitioning to a model where we expect our partner to contribute at least 50%to the cost of their courseware development. This new expense-sharing modelhelps to ensure the partner has a vested interest in the success of the course.VCampus and the partner typically co-own the completed online course. TheSelect Partners can therefore repurpose their highly-demanded training coursesfor online delivery to enhance and support their professional developmentprograms. The Select Partners benefit from our expert course development,publishing, hosting, e-commerce, reporting and account support and marketingservices. We enable these organizations to add online learning quickly,efficiently and relatively inexpensively. The Select Partner program enables usto reach these targeted markets through courses exclusively available on ourplatform.

As of March 2006, we had 14 Select Partners,through which we have released a total of 21 course titles and three exams andhave also converted 27 course titles from another hosting platform to ours. Weare currently developing four additional Select Partner courses for release. Underthis program, we have delivered more than 4,000 courses since completion of thepilot program in the fall of 2003.

Under our Legacy business model, our primary targetmarkets are the corporate, government and association member training markets.Since we are phasing out of and plan to ultimately exit the Legacy model, we nolonger devote significant resources to marketing to this market broadly.Instead, we focus our sales efforts on expanding revenue from our currentLegacy customers as well as pursuing promising leads and referrals that come toour attention.

As of March 2006, under the Legacy model we offermore than 3,800 online course titles and have delivered more than3.0 million courses to more than 1.0 million desktops/users sinceinception of the program in 1997.

We believe ourmarket strengths to be:

·       minimal upfrontinvestment required for customers;

·       ready-to-golibrary of more than 3,800 online courses;

·       consistentdelivery of high-quality courseware;

·       proven systemperformance and scalability;

·       exceptionalcustomer service and relationships; and

·       systemcompliance with industry standards including: SCORM (Shareable Content ObjectReference Model), Section 508 (of the Federal Rehabilitation Act), AICC(Aviation Industry Computer-based Training Committee—establishedstandards of interoperability) and SOAP (Simple Object Access Protocol).

We believe that we hold the following key advantagesin the e-Learning marketplace:

***Diversifiedbusiness base.  ***We serve customers from awide variety of market sectors—including corporations, government agencies,associations and professional credentialing and certification 

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organizations. Thisdiversification enables us to provide our customers with the opportunity andability to participate in and market themselves to multiple communities oflearning. The VCampus platform enables our customers to share content, therebycreating cross-sale opportunities from customer to customer. Several of ourcustomers successfully sell their content to other VCampus customers simply byoffering their content on the advanced VCampus platform.

***Open technology.  ***Ourtechnology affords customers a number of advantages in terms of its ability torapidly and cost-effectively implement a comprehensive and secure e-Learningand training environment. Our content-neutral, open architecture platformallows for access to a wide range of aggregated content and the ability toquickly add new functionality, leverage new technology and to support a vastnumber of users. Our web services capabilities enable customers to easilyintegrate our technology with other existing systems (including enterpriseresource planning, or ERP, systems and human resource information systems).

***Extensiveexperience.  ***We have operated in thee-Learning space for more than nine years and have delivered more than3.0 million courses to more than 1.0 million desktops/users. We maintainsolid, long-term relationships with established customers and benefit from ahighly experienced and knowledgeable management team. Our management team has acombined 48 years of experience in the e-Learning and related technologymarket.

***Expansive libraryof content aggregated from leading sources.  ***Ourexisting content library includes publicly-available online courses frommore than 40 publishers, including SkillSoft, ElementK, American Media, VitalLearning and Crisp Learning (Course Technology). We also distribute somecourseware that has been developed by our customers, such as the New YorkInstitute of Finance, to other VCampus customers. Our wholly-ownedlibrary of telecommunications courses is marketed under the Teletutor brandname. Finally, our Select Partner program enables our customers to sell or userecognized brand credentialing and certification courseware appropriate totheir market and/or employees or members.

***CoursewareDevelopment Experience.  ***We have significantcourseware development experience, built over the past ten years. We haveexperienced instructional designers and project managers on staff supplementedby offshore courseware development firms. We develop high quality courseware,implementing the latest designs for optimization of adult learning, quickly andcost effectively. The scalability of our courseware development infrastructureenables us to meet the growing demands of our Select Partners.

***Flexibility.  ***Theflexibility of our technology and implementation process enables us to respondto diverse customer needs. We offer rapid implementation on a content-neutralplatform that allows access to both off-the-shelf and proprietary courseware.We offer customization of our products and services for each customer, as wellas rapid incorporation of new technologies. Our technology and services aredesigned to be scaleable on demand to meet customer needs.

***Comprehensive Services.  ***Weoffer a completely hosted as well as behind-the firewall systems, accessible byvirtually any web browser. Our offerings include a leading edge LearningManagement System, Course Management System and Courseware Delivery Engine. Ourtechnology and service have been proven and tested through successfulimplementations for scores of customers, through which thousands of studentshave experienced VCampus-based e-Learning for up to nine years.Additionally, we continue to introduce new technology to provide additionalfeatures for our customers.

**Company Strategy**

Our goal is to be theleading service provider of integrated e-Learning services by helping customersimprove their performance and achieve their goals. Our strategies to achievethis objective include continuing to: create partnerships with leadingcredentialing and certification organizations; develop high 

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qualitycourseware quickly for our Select Partners; provide superior customer service;and develop new and upgrade existing technologies. Our strategy also includesincreasing revenue from each customer by converting more of each customer’sproprietary instructor-led content to online distribution through the VCampusplatform. We also intend to grow the cross-selling of content betweenvarious customers. The intended result is increased market penetration andenhanced customer loyalty.

*Create Partnershipswith Leading Credentialing Organizations*

The Select Partner program is our core focus forexpanding the business. Under this strategy, we seek to partner withorganizations that provide highly-sought credentialing or certificationservices to large addressable markets. Our target partners currently providemost, if not all, of their educational programs through instructor-ledprograms, thus leaving an under-addressed market opportunity for end users whoseek the credentialing or certification through an online course. By developingonline courses under our Select Parmer program, we are able to address thismarket opportunity jointly with these partners.

During 2004, we formed newrelationships with the following seven Select Partners, the majority of whichoffer credentials or training for learners interested in obtaining credentials:the Association for Financial Professionals, PCI Global, Inc., theNational Council of State Boards of Nursing, the National Contract ManagementAssociation, the American College of Forensic Examiners International, the NewYork Institute of Finance and Kiplinger Washington Editors, Inc. During2005 and through the first quarter of 2006, we formed new relationships withthe following four Select Partners: RegulatoryAffairs Professionals Society, Sourcefire, Inc., the CFA Instituteand the Emergency Nurses Association.

*Develop HighQuality Courseware Quickly for Select Partners*

Addressing the marketopportunity swiftly is essential to a successful Select Partner strategy. Withnearly a decade experience in the budding e-Learning industry, we havedeveloped the capabilities and expertise to fulfill the course developmentneeds of our current and new partners quickly, while delivering superiorquality. As such, we are able to work with our Select Partners to transformtheir traditional, instructor-led content into high-quality online courseswhile the market opportunity is still ripe.

*Provide SuperiorCustomer Service*

Our core customer serviceprinciple is to deliver uniquely superior service through creative, committedand well-trained employees who work as a team. Each VCampus employee hasdefined roles and responsibilities for monitoring and supporting the health andgrowth of our customer relationships. Furthermore, each team is responsible forcontinuous review of its customers’ content needs, introduction of existing andnew VCampus services, recommendation of suitable additional content,identification of the potential need for custom courseware development andrecommendation of platform configurations for customer-specific businessprocesses.

*Develop and UpgradeProprietary Technology*

We intend to maintain our market position in onlinecourseware delivery technology by continuing to develop and enhance thefeatures and functionality of our proprietary technology. Our system isdesigned to accommodate users on both low and high bandwidth connections.Additionally, our system is completely outsourced with little or no investmentin software or hardware required of customers or students (other than access tothe Internet via a web browser).

During 2003 and early 2004, weannounced the introduction of VCampus’ enhanced web-based CourseManagement System to support both self-paced and instructor-managed onlinelearning. The VCampus Course Management System (CMS) 5.0 delivers importantfeatures including a newly designed Gradebook that tracks multiple studentactivities, integrated course discussion boards, a built-in testing andassessment 

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engine, as well aspowerful communications tools. This CMS release marks the implementation of anew Java-based enterprise architecture designed for highly reliable, hostede-Learning. CMS 5.0 also includes a newly-designed course authoring tool.

Early in 2004, we introduced a new Learning ManagementSystem (LMS). This LMS, which we license from a third-party provider, providesour customers with the ability to support and manage online, live and blendedlearning. Capabilities include advanced LMS features, live chat, skillsassessment and multilingual capabilities. The LMS provides learners withconvenient access to course-specific data, supporting information andcommunications functions, all in one convenient location on the desktop. Thesystem also includes a personal calendar, reminder notes and other tools thatmake learning more efficient. The system is customizable and allows our clientsto obtain their own look, feel and features on a hosted basis. The new LMSintegrates with human resource, enterprise resource planning and customerrelationship management and other enterprise systems. In 2005, we continueddevelopment of both our CMS and Legacy LMS through feature and performanceenhancements. In addition, we started a project to develop a new assessmentsystem (to replace our legacy assessment system) which we plan to release by June 30,2006.

VCampus also developedVNexusTM, a next generation integration platform which made us the firste-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, we also offer othercommunication formats with VNexus.

*Existing CoursewareLibrary*

We currently offer morethan 3,800 courses real-time on our e-Learning system, the majority of whichare publicly-available courses. Our courseware strategy involves theprovision of the following three components: (1) strategically-developedcourses from VCampus based on Select Partner content; (2) COTS, orcommercial off-the-shelf, courses from a variety of leading third-partycourse vendors; and (3) custom courseware development for the proprietarytraining needs of our customers.

*StrategicallyDeveloped Courses*

We invest in thedevelopment of courses which we deem strategic in nature to attract customerswith strong revenue prospects. Typically, this type of course is developed inpartnership with a leading expert in the field, typically under the SelectPartner program. Content considered for co-development must target a large,reachable audience and offer the audience some compelling reason to attend thecourse (e.g., compliance with laws, certification, CPEs or CEUs). Examples ofstrategically-developed courses include Information Security and ProjectManagement courses. Courses so developed may be owned, at least partially, byus.

*COTS Library*

The majority of the online courses delivered from ourlibrary through our e-leaning system are commercial off-the-shelf, or COTS,courses. The current library was built from a combination of acquisitions, ourown development efforts and relationships with leading content providers suchas SkillSoft, Element K, Coastal Training Technologies, PureSafety, PCI Global,Course Technology Publications, Aztec Software and the New York Institute ofFinance. Although we do not provide accreditation or certification itself, anumber of our current courses provide either accreditation or certificationthrough our content providers.

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*Custom Library*

Our existing customcourseware library consists of online courses built by our legacy corporate,government agency, and association customers for their own proprietary use.Approximately 50% of these legacy customers have such custom courses rangingfrom a few courses to 50 or more per customer. We believe these coursesincrease customer retention and provide more long-term revenue potential thancommercial off-the-shelf courses, which have become commoditized.

**Customers**

Our primary target marketsfor our Select Partner program are professional credentialing and certificationorganizations, corporations, government agencies, and associations. In 2004,our online tuition revenues were balanced fairly equally among the government,corporate training and higher education distance learning customers with 4% oftotal revenues derived from professional credentialing and certificationorganizations. In 2005, total revenues were balanced fairly equally betweengovernment and corporate training customers with revenues derived fromprofessional credentialing and certification organizations at approximately 19%of our total revenues. We expect revenues from professional credentialing andcertification organizations to grow to a larger percentage of our totalrevenues in the coming years.

**Sales and Marketing**

Our primary marketing goals are to identify andattract organizations that offer the opportunity for developing significantrelationships with us. Our principal marketing and sales focus is the SelectPartner program. Our sales force and marketing efforts target organizationsthat offer highly-sought after professional credentials or certifications toorganizations with generally at least 10,000 members. We target organizationsthat, additionally, offer little to no online learning currently to theirmembers. In turn, under this program our Select Partners become a sales andmarketing channel for the courses we jointly introduce on the VCampus platform.

In the Legacy business, our sales and marketingefforts are limited and focused. Our primary target markets are the corporate,government and association member training markets. Since we are phasing out ofand ultimately exiting the Legacy model, we no longer devote significantresources to marketing to this market broadly. Instead, we focus our salesefforts on expanding revenue from our current Legacy customers as well aspursuing promising leads and referrals that come to our attention.

In addition to directsales efforts, we market our products and services through a variety of means,including Select Partners, the Web, public relations, trade shows, direct mail,trade publications, resellers and strategic partners. We believe that formingstrategic marketing alliances with channel partners who will sell, promote andmarket our products and services will be important for growth.

**Competition**

The market for online educational and trainingproducts and services is highly competitive and will likely intensify. Althoughwe know of no other company offering a program substantially similar to ourSelect Partner program, there are no significant barriers to entry in theonline education and training market. Competition in the market is based uponvarious factors, including technology, course offerings, pricing, quality,flexibility, reliability of delivery system, marketing and third partyrelationships.

A number of companies, including SkillSoft, SumTotalSystems, Saba and Pearson, compete in this market, as well as many others. Inaddition to traditional classroom and distance learning providers, otherinstitutions such as Apollo Group (through University of Phoenix Online) offertheir own accredited courses online. Many education providers use some of ourmethods, including e-mail, bulletin boards, 

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threaded discussion andelectronic conferencing, as well as other delivery methods such as satellitecommunications and audio and videotapes.

We believe that it isbecoming increasingly apparent that e-Learning providers must not only remaintechnologically advanced, but also, more importantly, offer “complete” serviceofferings. This “complete service offering” approach includes offeringcustomers: access to a large library of high quality, off-the-shelf courses;the ability to produce customized courses quickly and effectively; and value-addedfeatures that allow flexibility and scalability. Additionally, successfule-Learning services must be affordable, convenient and easy to use andadminister.

**Trademarks and Proprietary Rights**

We regard our copyrights,trademarks, trade dress, trade secrets and similar intellectual property ascritical to our success, and we rely upon federal statutory as well as commonlaw copyright and trademark law, trade secret protection and confidentialityand/or license agreements with our employees, customers, partners and others toprotect our proprietary rights. We own registered trademarks in the UnitedStates for: CoursewareConstruction Set, Pointpage, Content Matters, V (& design), VCampus (&design), www.vcampus.com, Select Partner and Govlearn. We have filedintent-to-use applications for the following: VCampus Your e-Learning Partner, VCMP, Unlock the Value of YourBranded Content and VCampus Professional Certification & DevelopmentCenter. We have licensed the right to use the web address www.vcmp.com.

**Employees**

As of March 1, 2006,we had 31 employees, consisting of eight full-time and three part-timeemployees in general business operations, six full-time employees in sales andmarketing, eight full-time employees in product development, and five full-timeand one part-time employee in finance and administration. None of our employeesis represented by a union and there have been no work stoppages. We believethat our employee relations are good.

**Whereyou can find additional information**

Our website address iswww.vcampus.com. We make available free of charge through our website ourannual report on Form 10-K, quarterly reports on Form 10-Q,current reports on Form 8-K, and all amendments to those reports assoon as reasonably practicable after such material is electronically filed withor furnished to the SEC.

**Item 1A.**                RiskFactors.

This report contains forward-looking statements thatinvolve risks and uncertainties. Our actual results could differ materiallyfrom those discussed in this report. Factors that could cause or contribute tothese differences include, but are not limited to, those discussed below andelsewhere in this report and in any documents incorporated in this report byreference.

If any of the following risks, or other risks notpresently known to us or that we currently believe to not be significant,develop into actual events, then our business, financial condition, results ofoperations or prospects could be materially adversely affected. If thathappens, the market price of our common stock could decline, and stockholdersmay lose all or part of their investment.

***We have incurredlosses and anticipate future losses, which could have an adverse impact on thetrading price of our common stock.***   We have incurred significant losses sinceour inception in 1984, including net losses attributable to common stockholdersof $6.2 million, $6.6 and $5.9 million for the years ended December 31,2003, 2004 and 2005, respectively. As of December 31, 2005, we had an 

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accumulated deficit of$102.9 million, stockholders’ equity of $2.7 million and working capitalof $0.7 million. We expect losses from operations to continue until ourSelect Partner business model matures. For these and other reasons, we cannot assureyou that we will ever operate profitably, which could have an adverse impact onthe trading price of the shares held by our stockholders.

***If we do not havethe resources to meet our business objective, we might not survive or besuccessful.******  ***Our key objective is to be one of theleading providers of outsourced e-Learning services. Pursuing this objectivemay significantly strain our administrative, operational and financialresources. We cannot assure you that we will have the operational, financialand other resources to the extent required to meet our business objective,which means we might not survive or be successful.

***Failure to raise additional capital, as and whenneeded, could prevent us from executing our business strategy and could preventus from maintaining compliance with Nasdaq listing standards.***   If weare not able to generate sufficient cash for ongoing operations, we will needto raise additional funds through public or private sale of our equity or debtsecurities or from other sources for the following purposes:

·       toexecute on our Select Partner business model;

·       tofund our operating expenses; and

·       tomaintain compliance with the minimum stockholders’ equity required forcontinued listing on Nasdaq.

We cannot assure you that additional funds will beavailable if and when we need them, or that if funds are available, they willbe on terms favorable to us and our stockholders. If we are unable to obtainsufficient funds or if adequate funds are not available on terms acceptable tous, we may be unable to meet our business objectives. A lack of sufficientfunds could also prevent us from taking advantage of important opportunities orbeing able to respond to competitive conditions. Any of these results couldhave a material adverse effect on our business, financial condition and resultsof operations.

Our need to raise additional funds could also directlyand adversely affect stockholder investment in our common stock in another way.When a company raises funds by issuing shares of stock, particularly at adiscount to the market price, the percentage ownership of the existingstockholders of that company is reduced, or diluted. If we raise funds in thefuture by issuing additional shares of stock (as we have in the past),stockholders may experience significant dilution in the value of their shares.Additionally, certain types of equity securities that we have issued in thepast, including our currently outstanding Series A-1 and B-1Preferred Stock, and may issue in the future could have rights,preferences or privileges senior to the rights of the holders of our commonstock.

We have in the past and may in the future fund theCompany with debt obligations which typically require payment of principal andinterest in cash, therefore, reducing the cash we would have available to meetoperating requirements. We began making quarterly principal and interestpayments in cash on our outstanding convertible debt in July 2005. Cashpayments for principal under these notes are $99,000 per quarter through thematurity date in April 2009. Initial cash payments for interest underthese notes were approximately $36,000 per quarter beginning July 2005 andwill gradually be reduced as the principal is paid down. Additionally, debtobligations may make additional financing offerings more difficult to enterinto which may result in less favorable financing terms for us.

***If we fail tomaintain compliance with our Nasdaq Capital Market listing, the value andliquidity of our shares could be impaired.***   Ourcommon stock is currently listed on the Nasdaq Capital Market (formerly knownas the Nasdaq SmallCap Market). Nasdaq has certain requirements that a companymust meet in order to remain listed on the Nasdaq Capital Market. 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 million stockholders’ equity requirement for 

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continued listing on theNasdaq Capital Market. At December 31, 2005, our stockholders’ equity was$2.7 million. To address our deficiency in the required minimumstockholders’ equity at September 30, 2005, we completed a $2.3 millionequity private placement of our Series A-1 Preferred Stock in December 2005,which permitted us to demonstrate stockholders’ equity of approximately $3.95million on a pro forma basis as of September 30, 2005 after giving effectto the net proceeds received in the financing. Nasdaq notified us in January 2006that we had regained compliance with the stockholders’ equity requirement. However,Nasdaq will continue to monitor our stockholders’ equity and we would becomesubject to delisting proceedings if we fail to remain in compliance. Wedemonstrated compliance with the stockholders’ equity requirement at December 31,2005 and our $2.3 million private placement of Series B-1 PreferredStock in March 2006 further increased our stockholders’ equity.

In addition, we received a notice in October 2005from the Nasdaq Stock Market indicating we were not in compliance with Nasdaq’srequirements for continued listing because, for the previous 30 consecutivebusiness days, the bid price of our common stock had closed below the minimum$1.00 per share requirement for continued inclusion under Nasdaq Marketplace Rule 4450(a)(5) (the“Minimum Bid Price Rule”). Nasdaq stated in its notice that in accordance withNasdaq Marketplace Rules, we will be provided 180 calendar days, or until April 26,2006, to regain compliance with the Minimum Bid Price Rule.

If at any time before April 26, 2006, the bidprice of our common stock closes at $1.00 per share or more for a minimum of 10consecutive business days, Nasdaq will provide us written notification that wehave achieved compliance with the Minimum Bid Price Rule. No assurance can begiven that we will regain compliance during the 180-day compliance period.The closing sale price of our common stock on March 20, 2006 was $0.62 pershare. If we do not regain compliance during the compliance period, Nasdaq wouldthen provide us with written notice that our common stock would be delistedfrom the Nasdaq Capital Market. The Nasdaq Capital Market and the NasdaqOver-the-Counter Bulletin Board are significantly less active markets than theNasdaq National Market. Stockholders could find it more difficult to dispose oftheir shares of our common stock than if our common stock were listed on theNasdaq National Market.

If our common stock were delisted from the NasdaqCapital Market, it could be more difficult for us to obtain other sources offinancing in the future. Moreover, if our common stock were delisted from theNasdaq Capital Market, our stock could be subject to what are known as the “pennystock” rules. The “penny stock” rules place additional requirements onbroker-dealers who sell or make a market in such securities. Consequently, ifwe were removed from the Nasdaq Capital Market, the ability or willingness ofbroker-dealers to sell or make a market in our common stock could decline. As aresult, the ability of our stockholders to resell their shares, and the priceat which they could sell their shares, of our common stock could be adverselyaffected. If our common stock were delisted from the Nasdaq Capital Market, itcould be more difficult for us to retain existing and obtain new customers. Theability to continue to form new strategic relationships may be negativelyimpacted. As a result, delisting could result in a negative impact on ourcustomer base and revenue, and, consequently, a negative impact on stockholdervalue.

***The large number ofour shares eligible for future sale could have an adverse impact on the marketprice of our common stock.******  ***A large numberof shares of common stock already outstanding, along with shares issuable uponexercise of options or warrants or conversion of convertible notes, areeligible for resale, which may adversely affect the market price of our commonstock. As of December 31, 2005, we had 9,592,074 shares of common stockoutstanding, 1,402,395 shares of common stock were issuable upon conversion of Series A-1Preferred Stock, another 849,946 shares were issuable upon conversion ofconvertible notes and another 7,080,163 shares were issuable upon exercise ofoutstanding warrants and options. Substantially all of the shares subject tooutstanding warrants and options will, when issued upon 

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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 theshares that are or will be eligible for future sale have been or will be issuedat discounts to the market price of our common stock on the date of issuance.

In December 2005, we issued 2,342 shares of Series A-1Preferred Stock (convertible into a total of 4,684,000 shares of common stockassuming the lowest reset conversion price of $0.50 per share) and warrants topurchase a total of 3,702,000 shares of common stock in a private placementfinancing and agreed to register the resale of all of these shares by May 2006.We have agreed to register for resale all of the shares of common stock issued orissuable in connection with our December 2005 financing. Resales or theprospect of resales of these shares may have an adverse effect on the marketprice of our common stock. See also the description of our recent Series B-1Preferred Stock financing, representing additional shares available for futureissuance, under the heading “Liquidity and Capital Resources” in the ManagementDiscussion and Analysis of Financial Condition and Results of Operations inthis report.

***Our substantialdependence on third-party relationships could impair our ability to achieve ourbusiness objectives and serve our customers.***   Werely on maintaining and developing relationships with customers, SelectPartners, professional credentialing and certification organizations and otherbusinesses that provide content for our products and services, corporations,government agencies, and associations and with companies that provide theInternet and related telecommunications services used to distribute ourproducts and services to customers.

We have relationships with a number of customers,professional credentialing and certification organizations and other businessesthat provide us with course content for our online products and services, aswell as access to their members who are the ultimate end users of our products.Some of the agreements we have entered into with these content providers limitour use of their course content, some do not cover use of any future coursecontent and most may be terminated by either party upon breach of the agreementby the other party or bankruptcy of the other party. For example, our agreementwith Certified Financial Analysts, or CFA, can be terminated by CFA in theevent our common stock is involuntarily delisted from the Nasdaq CapitalMarket. Our ASP-based business model is not compatible with the business modelsof certain content providers which may lead them to terminate the futurelicensing of existing and new course content to us or fail to make this contentavailable to us at commercially reasonable rates or terms necessary for successunder our business model. Given our plans to introduce additional onlinecourses in the future, we will need to license new course content from existingand prospective content providers. However we might not be able to maintain andmodify, if necessary, our existing agreements with content providers, orsuccessfully negotiate agreements with prospective content providers. If thefees we pay and/or the expenses we incur to acquire or distribute contentincrease, our operating costs and results of operations could be adverselyaffected. We might not be able to license or otherwise acquire course contentat commercially reasonable rates or at all.

We have licensed a Learning Management System from athird party provider under an agreement that expires on December 31, 2008.If the provider does not perform on the contract, does not continue to upgradeand maintain the LMS, does not renew the agreement with VCampus or in someother way impairs our ability to provide the LMS to our customers, our abilityto compete would be adversely affected.

We depend heavily on third-party providers of Internetand related telecommunications services. In order to reach customers, ourproducts and services have to be compatible with the web browsers theytypically use. Our customers have access to us through their arrangements withInternet service providers. We also depend heavily on the third-party providerof our off-site data center and the related utilities (electricity and HVAC),physical security and access, and Internet services that it provides.

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For our customers,the professional credentialing and certification organizations and otherbusinesses that provide content for our products and services, the companiesthat provide the Internet and related telecommunications services used todistribute our products and services to customers, and the web-site operatorsthat provide links to our company web-sites, we cannot assure you that:

·       theyregard their relationships with us as sufficiently important to their ownbusinesses and operations;

·       theywill not reassess their commitment to our products or services at any time inthe future;

·       theywill not develop their own competitive products or services;

·       theproducts or services by which they provide access or links to our products orservices will achieve market acceptance or commercial success; or

·       ourrelationships with them will result in successful product or service offeringsor generate significant revenues.

If one or more of these entities fail to achieve ormaintain market acceptance or commercial success, or if one or more of theentities that do succeed decide to end their relationship with us, we might notbe able to generate sufficient revenues to be successful and stockholderinvestment would be impaired.

***We may be unable to effectively integrate anyacquisitions we might make, which could disrupt or have a negative impact onour business.***   Part of our growth strategy includespursuing acquisitions. Any integration process may be complex and timeconsuming, may be disruptive to the business and may cause an interruption of,or a distraction of management’s attention from, the business as a result of anumber of obstacles, including but not limited to: 

·       *the loss of key customers of the acquired company;*

·       *the incurrence of unexpected expenses and working capital requirements;*

·       *a failure of our due diligence process to identify significant issuesor contingencies or to properly assess the value and determine an appropriatepurchase price;*

·       *difficulties assimilating the operations and personnel of the acquiredcompany;*

·       *difficulties effectively integrating the acquired technologies with ourcurrent technologies;*

·       *Our inability to retain key personnel of acquired entities;*

·       *failure to maintain the quality of customer service;*

·       *Our inability to achieve the financial and strategic goals for theacquired and combined businesses; and*

·       *difficultyin maintaining internal controls, procedures and policies.*

*Any of the foregoing obstacles, or a combination ofthem, could increase selling, general and administrative expenses in absoluteterms and/or as a percentage of net sales, which could in turn negativelyimpact our net income and cash flows.*

As part of our plans to grow our business, weperiodically evaluate potential acquisition candidates that we believe wouldcompliment our e-Learning business. We have limited experience acquiring otherbusinesses and there can be no assurance that we will be successful completingacquisitions or integrating the operations of acquired companies into ourbusiness. We cannot predict the effect expansion may have on our core business.Regardless of whether we are successful in completing any acquisitions, thenegotiations could disrupt our ongoing business, distract our management andemployees and increase our expenses.

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***Our facilities,personnel and financial and management systems may not be adequate to effectivelymanage the future expansion we believe necessary to increase our revenues andremain competitive.***   Weanticipate that future expansion will be necessary in order to increase ourrevenues. In order to effectively manage our expansion, we may need to attractand hire additional sales, administrative, operations and management personnel.We cannot assure you that our facilities, personnel and financial andmanagement systems and controls will be adequate to support the expansion ofour operations, and provide adequate levels of service to our customers andpartners. If we fail to effectively manage our growth, our business could beharmed.

***We operate in ahighly competitive industry and may not be able to compete effectively.*****  **The market for online educational and trainingproducts and services is highly competitive and we expect that competition willcontinue to intensify. There are no substantial barriers to entry into ourbusiness, and we expect that established and new entities will enter the marketfor online educational and training products and services in the near future.

A number of our existing competitors, as well as anumber of potential new competitors (including some of our strategic partners),have longer operating histories, greater name recognition, larger customerbases, more diversified lines of products and services and significantlygreater resources than we do. Such competitors may be able to undertake moreextensive marketing campaigns, adopt more aggressive pricing policies and makemore attractive offers to potential customers. In the past few years, a numberof our customers have demanded upgrades to our technology platform. Ourrelatively limited capital resources might not afford us a full opportunity tomeet these demands. Recently, we have noticed that some of the more widelyavailable online course offerings, particularly those targeted to the corporatetraining market, are increasingly competing primarily on price, whichcommoditization drives down margins for all competitors in our industry. Incompeting against us, our strategic partners could use information obtainedfrom us to gain an additional competitive advantage over us. Our current andpotential competitors might develop products and services that are superior toours or that achieve greater market acceptance than ours. We might not competeeffectively and competitive pressures might prevent us from acquiring andmaintaining the customer base necessary for us to be successful.

As the revenue potential for online delivery ofeducational and training courses continues to grow, the market is likely toattract a number of large, well-capitalized competitors seeking to diversifytheir revenue streams into this market. Not only will some of these potentialcompetitors be well capitalized and be willing to operate in the market at aloss to build market share, they may also acquire and/or substantially fund ourother competitors which could weaken demand for our products and make it moredifficult for us to reach or even prevent us from reaching profitability.

***The loss ofservices of any member of our key personnel could prevent us from adequatelyexecuting on our business strategy.*****  **Our future success depends on thecontinued contributions of our key senior management personnel, consisting ofNarasimhan Kannan, Chief Executive Officer, Christopher Nelson, Chief FinancialOfficer, Ronald Freedman, Senior Vice President, e-Learning Solutions, LauraFriedman, Vice President—Co-Publishing, and Kerry Frederick, Vice President ofContent Sales. We do not maintain “key man” life insurance on any of ourexecutive officers. The loss of services of any of our key managementpersonnel, whether through resignation or other causes, or the inability toattract qualified personnel as needed, could prevent us from adequatelyexecuting our business strategy.

***Our results ofoperations have fluctuated significantly from period to period, and a failureto meet the expectations of investors or the financial community at large couldresult in a decline in our stock price.***   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 

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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 may fluctuate significantly inthe future as a result of a variety of factors, some of which are outside ofour control. These factors include:

·       demandfor online education and especially the demand for professional certificationand continuing education;

·       thebudgeting cycles of customers, particularly in the government sector;

·       seasonalityof revenues corresponding to holidays in the United States;

·       capitalexpenditures and other costs relating to the expansion of operations or theacquisition of complimentary businesses;

·       theintroduction of new products or services by us or our competitors;

·       themix of the products and services sold and the channels through which thoseproducts and services are sold;

·       pricingor accounting changes; and

·       generaleconomic conditions.

As a strategic response to a changing competitiveenvironment, we may elect from time to time to make certain pricing, service ormarketing decisions that could have a material adverse effect on us. We believethat period-to-period comparisons of our operating results should not be reliedupon as an indication of future performance. Due to all of the foregoingfactors, it is possible that in some future quarter, our operating results willbe below the expectations of public market analysts and investors. In suchevent, the price of our common stock would likely decline. We also believe thatthe price of our shares has been adversely affected, and may continue to beadversely affected, by short sales by unknown groups and by the involuntarylisting of our shares in the unregulated Berlin Stock Exchange. The BerlinStock Exchange is known to permit “naked shorts” and creates anenvironment for the speculation in shares that is not permitted under U.S. law.

***We rely onsignificant customers, and if we fail to maintain and develop relationshipswith such customers, we might not generate revenues necessary to achieve ourbusiness objectives.***   A significant portion of our revenues isgenerated by a limited number of customers. For the twelve months ended December 31,2005, two customers, the U.S Department of Veterans’ Affairs and a largeinsurance company, accounted for approximately 36% and 20% of our revenues,respectively. In 2004, three customers, the U.S. Department of Veterans’Affairs, Park University and a large insurance company, accounted forapproximately 27%, 25% and 21% of our revenues, respectively. We expect that wewill continue to depend on large contracts with a limited number of significantcustomers at least through the near future. This situation can cause ourrevenue and earnings to fluctuate between quarters based on the timing ofcontracts. Most of our customers have no obligation to purchase additionalproducts or services from us.

Park University elected not to renew its relationshipwith VCampus as of May 2004. Park University represented 25% of VCampusrevenues in 2004 and 36% in 2003. In addition to the loss of the revenue fromPark University, our ability to compete effectively in the higher educationmarket space has been adversely impacted by the loss of this customer.

If we fail to maintain and develop relationships withsignificant customers, we might not be able to generate revenues necessary toachieve our business objectives.

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***We rely heavily ona limited number of contracts with the U.S. government, which are subject totermination for convenience by the government at any time. While we haveexperienced no such terminations and have had contracts with these agencies fora number of years, should such terminations occur, they could cause a materialadverse impact on our operations.***   During the twelve months ended December 31,2005 and 2004, 39% and 35%, respectively, of our net revenues were derived fromperformance on a limited number of contracts with U.S. government agencies,primarily the Department of Veterans Affairs, which represented 36% and 27% ofour net revenues for the twelve months ended December 31, 2005 and 2004,respectively. Therefore, any significant disruption or deterioration of ourrelationship with the U.S. government agencies with which we do business wouldsignificantly reduce our revenues. Our competitors continuously engage inefforts to expand their business relationships with the government and arelikely to continue these efforts in the future. Our contracts with thegovernment are generally multiyear contracts, however, they are subject tonon-renewal annually, as well as termination by the government for convenienceat any time. The government may choose to use contractors with competingtechnologies or it may decide to discontinue any of our programs altogether. Inaddition, the contracts that we do obtain require ongoing compliance withapplicable government regulations. Termination of our contracts, a shift ingovernment spending to other programs in which we are not involved, a reductionin government spending generally, or our failure to meet applicable governmentregulations could have a material adverse impact on our operations.

***System failures andcapacity constraints could interfere with our efforts to attract customers andattain market acceptance of our products and services.***   A keyelement of our strategy is to generate a high volume of online traffic to ourproducts and services. Accordingly, the performance of our products andservices is critical to our reputation, our ability to attract customers andattain market acceptance of our products and services. Any system failure thatcauses interruptions in the availability or increases response time of ourproducts and services would result in less usage of our products and servicesand, especially if sustained or repeated, would reduce the attractiveness ofour products and services. For example, in 2005 we experienced a number of “downtimes”with our data center provider that we consider unacceptable. Although we havetaken actions to remedy these failures, they might recur. In addition, oursystem has single points of failure and requires a weekly maintenance window,both of which increase the time the system is unavailable to our users. Anincrease in the volume of use of our products and services could strain thecapacity of the software or hardware we use or the capacity of our networkinfrastructure, which could lead to slower response time. Any failure to expandthe capacity of our hardware or network infrastructure on a timely basis or oncommercially reasonably terms would reduce the attractiveness of our productsand services. We also depend on web browsers and Internet service providers foraccess to their products and services, and users may experience difficultiesdue to system failures unrelated to our systems, products and services.

***If the security ofinformation stored in and transmitted through computer systems of VCampus andits end-users is not adequately secured, we could incur significant liabilityand potential customers might be deterred from using our products and services.***   Weinclude in our products certain security protocols that operate in conjunctionwith encryption and authentication technology. In addition, we monitor oursystem with intrusion detection devices. Despite these technologies, ourproducts may be vulnerable to break-ins and similar disruptive problems causedby online users. Such computer break-ins and other disruptions would jeopardizethe security of information stored in and transmitted through our computersystems and the computer systems of end-users, which may result in significantliability for us and may also deter potential customers. For example, computer “hackers”could steal, remove or alter portions of our online courseware or customerpayment and identification information. Persistent security problems continueto plague the Internet, the Web and other public and private 

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data networks. Alleviatingproblems 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 somesituations.

***We might not besuccessful in responding to the changing market for our products and services.******  ***The market forour products and services is evolving in response to recent developmentsrelating to online technology. The market is characterized by evolving industrystandards and customer demands and an increasing number of market entrants whohave introduced or developed online products and services. It is difficult topredict the size and growth rate, if any, of this market. As is typical in thecase of a rapidly evolving industry, demand and market acceptance for recentlyintroduced products and services are subject to a high level of uncertainty.Our future success will depend in significant part on our ability to continueto improve the performance, features and reliability of our products andservices in response to both evolving demands of the marketplace andcompetitive product offerings, and we cannot assure that we will be successfulin developing, integrating or marketing such products or services. In addition,our new product and courseware releases may contain undetected errors thatrequire significant design modifications, resulting in a loss of customerconfidence.

***We might not beable to adequately protect our intellectual property rights.******  ***We regard ourcopyrights, trademarks, trade secrets and similar intellectual property ascritical to our success, and we rely upon trademark and copyright law, tradesecret protection and confidentiality and/or license agreements with ouremployees, customers, partners and others to protect our proprietary rights.

We have had certain trademark applications denied andmay have more denied in the future. We will continue to evaluate the need forregistration of additional marks as appropriate. Despite our efforts to protectour proprietary rights, unauthorized parties may attempt to copy aspects of ourproducts or services or to obtain and use information that we regard asproprietary. In addition, the laws of some foreign countries do not protectproprietary rights to as great an extent as do the laws of the United States.Litigation may be necessary to protect our proprietary technology. Any suchlitigation may be time-consuming and costly, cause product release delays,require us to redesign our products or services or require us to enter intoroyalty or licensing agreements, any of which could have a material adverseeffect upon us. For example, we were forced to pursue legal action during 2004to prevent unauthorized use of the web address www.vcampus.us and we arecurrently pursuing efforts to eliminate the unauthorized use of the domain namewww.vcampus.ch by a third party. These royalty or licensing agreements, ifrequired, may not be available on terms acceptable to us or at all. Our meansof protecting 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 might not be ableto realize the full value of our intellectual property rights.

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***Governmentregulation of business conducted on the Internet could decrease the demand forour products and services or increase our cost of doing business.***   Thereare currently few laws or regulations that directly apply to activities on theInternet. We believe that we are not currently subject to direct regulation byany government 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. For example, we have an open matter beforethe Virginia Department of Taxation as to whether we owe use tax on third-partyroyalties paid by us to content providers for courses we delivered online. Anynew legislation or regulation, or application or interpretation of existinglaws, could decrease online demand for our products and services or increaseour costs.

***We could issueadditional preferred stock and take other actions that might discourage thirdparties from acquiring us.******  ***Our board ofdirectors has the authority, without further action by the stockholders, toissue shares of preferred stock and to fix the rights, preferences, privilegesand restrictions, including voting rights, of such shares. In December 2005,we created and issued a new class of Series A-1 Preferred Stock. Therights of the holders of the common stock will be subject to, and may beadversely affected by, the rights of the holders of the Series A-1Preferred Stock and any other preferred stock that we may issue in the futuresuch as the new class of Series B-1 Preferred Stock we created andissued in March 2006. Issuing preferred stock could have the effect ofmaking it more difficult for a third party to acquire a majority of ouroutstanding voting stock, thereby delaying, deferring or preventing a change incontrol of our company. Furthermore, the preferred stock may have other rights,including economic rights, senior to our common stock, and as a result, theexisting or future preferred stock could decrease the market value of ourcommon stock.

Certain provisions of our certificate of incorporationand our bylaws could make it more difficult for a third party to acquire, andcould discourage a third party from attempting to acquire, control of VCampus. Someof them eliminate the right of stockholders to act by written consent andimpose various procedural and other requirements which could make it moredifficult for stockholders to undertake certain corporate actions. Theseprovisions could limit the price that certain investors might be willing to payin the future for shares of our common stock and may have the effect ofdelaying or preventing a change in control of VCampus. We may in the futureadopt other measures that may have the effect of delaying, deferring orpreventing a change in control of VCampus. Certain of these measures may beadopted without any further vote or action by the stockholders, although wehave no present plans to adopt any such measures. We are also afforded theprotections of Section 203 of the Delaware General Corporation Law, whichcould delay or prevent a change in control of VCampus, impede a merger,consolidation or other business combination involving our company or discouragea potential acquirer from making a tender offer or otherwise attempting toobtain control of VCampus.

***We might not beable to use net operating loss carryforwards.******  ***As of December 31,2005, we had net operating loss carryforwards for federal income tax purposesof approximately $69.7 million, which will expire at various dates through2025. Our ability to use these net operating loss and credit carryforwards tooffset future tax obligations, if any, may be limited by changes in ownership. Specifically,management believes that deemed changes in ownership resulting from our recentequity financings will likely prevent us from using part or all of the netoperating losses and credit carryfowards under the IRS change in 

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ownership rules. We haverecognized a full valuation allowance against these deferred tax assets becausewe have determined that it is more likely than not that sufficient taxableincome will not be generated during the carryforward period available under thetax law to utilize the deferred tax assets. Any limitation on the use of netoperating loss carryforwards, to the extent it increases the amount of federalincome tax that we must actually pay, may have an adverse impact on ourfinancial condition.

***We do not presently anticipate paying cash dividendson our common stock.******  ***We intend to retain all earnings,if any, for the foreseeable future for funding our business operations.Consequently, we do not anticipate paying any cash dividends on our commonstock for the foreseeable future, which could deter some investors from seekingto acquire our common stock.

**SPECIAL NOTE REGARDING FORWARD-LOOKINGSTATEMENTS**

Some of thestatements contained in this report discuss our plans and strategies for ourbusiness and are “forward-looking statements” as that term is defined inthe Private Securities Litigation Reform Act. The words “anticipates,” “believes,”“estimates,” “expects,” “plans,” “intends” and similar expressions are meant toidentify these statements as forward-looking statements, but they are notthe exclusive means of identifying them. The forward- looking statementsin this report reflect the current views of our management; however, variousrisks, uncertainties and contingencies could cause our actual results,performance or achievements to differ materially from those expressed orimplied by these statements, including:

·       ourhistory of losses and negative operating cash flows;

·       theuncertainties and risks we face relating to our Nasdaq Capital Market listing;

·       thelarge number of our shares eligible for future sale could have an adverseimpact on the market price of our common stock;

·       ourfuture capital needs and the uncertainty of additional funding;

·       ourpotential inability to compete effectively;

·       adeveloping market, rapid technological changes and new products;

·       risksassociated with acquisitions and expansion;

·       ourdependence on significant clients;

·       oursubstantial dependence on courseware and third-party coursewareproviders;

·       oursubstantial dependence on third-party relationships; and

·       changesin accounting methods or estimates underlying these methods.

We assume no obligation toupdate publicly any forward-looking statements, whether as a result ofnew information, future events or otherwise. In light of the risks anduncertainties discussed in this section and elsewhere in this report, eventsreferred to in forward-looking statements in this report might not occur.

**Item 1B.**               Unresolved Staff Comments.

Not applicable.

**Item 2.**                        Properties.

Our executive offices andprincipal administration, technical, marketing and sales operations are locatedin approximately 16,700 square feet of leased space in Reston, Virginiapursuant to a lease that 

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expiresin February 2010. The aggregate annual monthly rent for this facility is$43,965, subject to 3% annual increases. We believe that our existing officespace is sufficient to accommodate our current needs and that suitableadditional space will be available on commercially reasonable terms toaccommodate any expansion needs through 2006 should the need arise.

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

Although we are notcurrently involved in any material pending legal proceedings, we could be subject to legal proceedings andclaims in the ordinary course of our business or otherwise, including claimsrelating to license agreements, royalties or claims of alleged infringement ofthe trademarks and other intellectual property rights of third parties by usand our licensees.

**Item 4.**                        Submission of Matters to a Vote of SecurityHolders.

Nomatters were submitted to a vote of security holders during the fourth quarterended December 31, 2005.

**Executive Officers**

As of March 20,2006, our executive officers were as follows:

| **Name**               | ** ** | ** ** | ** ** | **Age**                                                           | ** ** | **Positions** |
|------------------------|------------|------------|------------|-------------------------------------------------------------------|------------|---------------|
| Nat  Kannan            |       | 56         |       | Chairman  and Chief Executive Officer                             |
| Christopher  L. Nelson |       | 43         |       | Chief Financial Officer,  Chief Information Officer and Secretary |
| Kerry  A. Frederick    |       | 53         |       | Vice  President, Content Sales                                    |
| Ronald  E. Freedman    |       | 56         |       | Senior Vice President,  e-Learning Solutions                      |
| Laura B. Friedman      |       | 44         |       | Vice President, Co-Publishing                                     |

 

*Narasimhan“Nat” Kannan*has served as VCampus’ Chairman of theBoard of Directors since he founded VCampus in 1984. He resumed the ChiefExecutive Officer position in December 2002, a position he formerly heldfrom 1984 to 2000. Prior to founding VCampus, he co-founded Ganesa Group, Inc.,a developer of interactive graphics and modeling software, in 1981. He alsoserved as a consultant to Booz Allen and Hamilton, Inc., the MITRECorporation, The Ministry of Industry of the French Government, the Brookhavenand Lawrence Livermore National Laboratories, the White House Domestic PolicyCommittee on Energy and Control Data Corporation. He holds a B.S. inEngineering from the Indian Institute of Technology in Madras, India, and heperformed advanced graduate work in business and engineering at DartmouthCollege.

*Christopher L.Nelson*joined VCampus as Chief Financial Officer andChief Information Officer in June of 2002. Mr. Nelson oversees theentire technology, operations and customer service areas of the business inaddition to his finance and accounting department responsibilities. Prior tohis appointment as our CFO, Mr. Nelson was a Principal of MonticelloCapital LLC since 1998, where he advised high-growth technology businesses andtheir corporate boards on corporate finance, capitalization transactions, andmergers and acquisitions. Mr. Nelson held positions as CEO, COO and CFO ofniche, high tech companies in the Internet space prior to joining VCampus(including Kignet, Inc., Monumental Network Systems, and IMA Software, Inc.)during which he developed particular expertise in bringing companies to cashflow positive positions. Mr. Nelson also held executive positions atNTT/Verio, as well as sales and marketing and manufacturing positions at IBMCorporation. Mr. Nelson holds a Master of Business Administration from TheWharton School at the University of Pennsylvania and a Bachelor of Sciencedegree in Chemical Engineering from the University of Delaware. Mr. Nelsonalso previously served as a George Mason Fellow, acting as an advisor tostart-up and early stage technology companies on a volunteer basis through theTechVenture Partnership at George Mason University.

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*KerryA. Frederick*joined VCampus as Vice President ofcontent sales in October 2005. In that position, he leads our efforts toaccelerate the growth of our Select Partner courseware revenues through globalchannels and enterprise sales. Prior to joining VCampus, Mr. Frederick wasthe Vice President of Sales for Knowlagent, Inc., an Atlanta,Georgia-based provider of web-based learning and performance improvementsolutions, since 2001. At Knowlagent he developed a targeted approach toexpanding coverage and creating greater value for the Knowlagent solutionresulting in significant increases in customers and revenue as well as marketexpansion in Europe. Prior to working at Knowlagent, he was a partner and VicePresident of Sales for Technology Ventures, Inc., a private investmentfirm which invested in a number of portfolio companies, including The McCallConsulting Group, which has provided consulting services and high-endcertification training for a variety of software development solutions since1993. He holds Bachelors and Masters Degrees in Business from Georgia StateUniversity and has done advanced studies in Marketing Management from StanfordUniversity Graduate School of Business.

*RonaldE. Freedman*is responsible for e-Learning Solutionsales with a particular emphasis on the government market. Mr. Freedmanhas more than 20 years of hands-on experience in sales management,strategic planning, business development, and execution of profit and lossresponsibility. Mr. Freedman joined VCampus in 2001 from USinternetworking, Inc.(USi) where he was Vice President of Information Assurance and Chief SecurityOfficer from 1999 through 2001. While at USi, he was responsible for thedesign, implementation and management of the USi Total Security Architecture, abest-of-breed security portfolio. Prior to joining USi, Freedman was VicePresident of one of the business divisions at The Netplex Group, Inc. forfour years. There, he was responsible for sales, marketing and fulfillment of awide range of technology-based products and services. Previously, Mr. Freedmanwas Vice President, Systems and Services for COMSIS Corporation, where hemanaged the division of the professional services company providing contingencyplanning and information security services to commercial and governmentcustomers. He also served as Executive Vice President of Advanced InformationManagement, Inc., where he was responsible for marketing and deliveringinformation security and contingency planning services to Fortune 500 customers.Mr. Freedman worked for General Electric Company for fifteen years, mostrecently as General Manager, Disaster Recovery Services and Manager, StrategicPlanning and Business Development. He also served as a Presidential appointee,on loan to The White House from General Electric, responsible for developingcontingency plans as part of the Continuity of Government Program. Mr. Freedmanholds a BA in Economics from Northeastern University in Boston and an MBA inManagement from Babson College in Wellesley, MA. He currently serves asChairman of ITAA’s e-Learning Committee.

*LauraB. Friedman*is responsible for developing and managingpartnerships under the Select Partner program and for our courseware productiongroup, or Custom Design Studio. Ms. Friedman is an experiencedprofessional publishing executive, having served for more than 17 years in avariety of marketing, editorial and content development positions in bothtraditional and electronic publishing. Prior to joining VCampus, she served asVice President of Learning Services at Zoologic, Inc. from November 2002to August 2004. A long time supporter of e-Learning, she founded thee-Learning program at The New York Institute of Finance (NYIF), Pearson’sfinancial training division, where she was Vice President of e-Learning from May 1996to November 2002. In addition to creating NYIF’s portfolio of onlinecourses in financial training, Laura oversaw custom development projects forclients such as Accenture, Arthur Andersen and the Financial Times. She servedas Director, International Marketing for Business, Professional and Referenceproducts at Simon & Schuster. At McGraw-Hill and Time Warner’sBook-of-the-Month Club, Ms. Friedman held a variety of editorial andmarketing positions in professional publishing. She holds a B.A. from the StateUniversity at Albany and a MBA from Fordham University.

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**PART II**

**Item 5.**                        Market for Registrant’s Common Equity and RelatedStockholder Matters.

(a)*           Price Range of Common Stock*

Our common stock is currently listed and trades on theNasdaq Capital Market under the symbol “VCMP.” For each full fiscal quartersince the beginning of 2004, the high and low bid quotations for our commonstock, as reported by Nasdaq, were as follows:

| ** **     | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| **2004**       |       |     |       |    |       |
| First quarter  |       | $        | 3.74       |    | $          | 1.42 |   |
| Second quarter |       | $        | 10.00      |    | $          | 1.95 |   |
| Third quarter  |       | $        | 3.20       |    | $          | 1.03 |   |
| Fourth quarter |       | $        | 2.95       |    | $          | 1.04 |   |
| **2005**       |       |     |       |    |       |
| First quarter  |       | $        | 2.33       |    | $          | 1.31 |   |
| Second quarter |       | $        | 1.72       |    | $          | 0.85 |   |
| Third quarter  |       | $        | 1.49       |    | $          | 0.71 |   |
| Fourth quarter |       | $        | 1.00       |    | $          | 0.41 |   |

 

The foregoing bid quotationsreflect inter-dealer prices, without retail mark-ups, mark-downs orcommissions, and may not represent actual transactions.

Since our IPO in late 1996, the public market for our common stock hasbeen characterized by low and/or erratic trading volume, often resulting inprice volatility. There can be no assurance that there will be an active publicmarket for our common stock in the future. The market price of the common stockcould be subject to significant fluctuations in response to futureannouncements concerning us or our partners or competitors, the introduction ofnew products or changes in product pricing policies by us or our competitors,proprietary rights or other litigation, general conditions in the e-Learningmarket, developments in the financial markets and other factors. In addition,the stock market has, from time to time, experienced extreme price and volumefluctuations that have particularly affected the market prices for technologycompanies and which have often been unrelated to the operating performance ofthe affected companies. Broad market fluctuations of this type may adverselyaffect the future market price of the common stock. See “Item 7. Management’sDiscussion and Analysis of Financial Condition and Results of Operations—Liquidityand Capital Resources.”

(b)*          Approximate Number of Equity Security Holders*

As of March 20, 2006, the number of record holders of our CommonStock was 126 and we believe that the number of beneficial owners wasapproximately 2,000.

(c)*           Dividends*

We have never paid a cashdividend on our common stock and we do not anticipate paying cash dividends inthe foreseeable future. Moreover, any preferred stock that we could issue inthe future and any future credit facilities might contain restrictions on ourability to declare and pay dividends on our common stock. We plan to retain allearnings, if any, for the foreseeable future for use in the operation of ourbusiness and to fund the pursuit of future growth. Future dividends, if any,will depend on, among other things, our results of operations, capitalrequirements and on such other factors as our Board of Directors, in itsdiscretion, may consider relevant.

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**Item 6.**                        Selected Financial Data.

The following selectedconsolidated financial data should be read in conjunction with our consolidatedfinancial statements and the related notes, and with “Management’s Discussionand Analysis of Financial Condition and Results of Operations,” includedelsewhere in this annual report. The statement of operations data for the yearsended December 31, 2003, 2004 and 2005, and the balance sheet data as of theyears then ended, are derived from, and are qualified by reference to, ouraudited consolidated financial statements that have been audited by ReznickGroup, P.C., our independent auditors. The statement of operations data for theyears ended December 31, 2001 and 2002, and the balance sheet data as ofthe years then ended, are derived from, and are qualified by reference to, ouraudited consolidated financial statements that have been audited by Ernst &Young LLP, our prior independent auditors.

**Statement of Operations Data:**

| ** **                                     | ** ** | **2001**                                                          | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** |
|------------------------------------------------|------------|-------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| ** **                                     | ** ** | **(In thousands except per share data)** | ** ** |
| Net revenues:                                  |       |                                                              |       |     |       |     |       |     |       |     |       |
| Online tuition revenues                        |       | $                                                                 | 5,782      |     | $          | 5,330    |       | $        | 5,508      |     | $          | 4,498 |   | $ | 4,046 |   |
| Virtual campus software revenues               |       | 72                                                                |       | —   |       | —   |       | —   |       | —   |       |
| Online development and other revenues          |       | 687                                                               |       | 496      |       | 448      |       | 318      |       | 518      |       |
| Product sales revenues                         |       | 45                                                                |       | —   |       | —   |       | —   |       | —   |       |
| Other service revenues                         |       | 122                                                               |       | 100      |       | 110      |       | 48       |       | —   |       |
| Instructor-led training revenues               |       | 102                                                               |       | —   |       | —   |       | —   |       | —   |       |
| Total net  revenues                            |       | 6,810                                                             |       | 5,926    |       | 6,066    |       | 4,864    |       | 4,564    |       |
| Costs and expenses:                            |       |                                                              |       |     |       |     |       |     |       |     |       |
| Cost of revenues                               |       | 1,093                                                             |       | 1,462    |       | 1,718    |       | 1,357    |       | 1,731    |       |
| Sales and marketing                            |       | 4,554                                                             |       | 2,689    |       | 2,138    |       | 1,895    |       | 1,723    |       |
| Product development and operations             |       | 2,273                                                             |       | 2,536    |       | 2,475    |       | 2,725    |       | 2,649    |       |
| General and administrative                     |       | 2,045                                                             |       | 1,693    |       | 1,910    |       | 1,687    |       | 1,488    |       |
| Depreciation and amortization                  |       | 2,154                                                             |       | 1,356    |       | 880      |       | 1,227    |       | 1,574    |       |
| Reorganization and other non-recurring charges |       | 188                                                               |       | 192      |       | 173      |       | —   |       | —   |       |
| Stock-based compensation                       |       | 441                                                               |       | 76       |       | 126      |       | 154      |       | 110      |       |
| Total costs and  expenses                      |       | 12,748                                                            |       | 10,004   |       | 9,420    |       | 9,045    |       | 9,275    |       |
| Loss from operations                           |       | (5,938                                                            | )          | (4,078   | )          | (3,354   | )          | (4,181   | )          | (4,711   | )          |
| Other income  (expense):                       |       |                                                              |       |     |       |     |       |     |       |     |       |
| Other income                                   |       | —                                                            |       | 422      |       | 207      |       | 183      |       | —   |       |
| Interest income (expense)                      |       | 5                                                                 |       | (220     | )          | (112     | )          | (2,581   | )          | (1,155   | )          |
| Loss on debt extinguishments                   |       | —                                                            |       | (503     | )          | —   |       | —   |       | —   |       |
| Net loss                                       |       | $                                                                 | (5,933     | )        | $          | (4,379   | )          | $        | (3,259     | )        | $          | (6,579 | ) | $ | (5,866 | ) |
| Dividends to  preferred stockholders           |       | (649                                                              | )          | (2,768   | )          | (2,927   | )          | —   |       | (14      | )          |
| Net loss  attributable to common stockholders  |       | $                                                                 | (6,582     | )        | $          | (7,147   | )          | $        | (6,186     | )        | $          | (6,579 | ) | $ | (5,880 | ) |
| Net loss per  share                            |       | $                                                                 | (5.23      | )        | $          | (4.79    | )          | $        | (1.81      | )        | $          | (0.97 | ) | $ | (0.63 | ) |
| Net loss per  share—assuming dilution     |       | $                                                                 | (5.23      | )        | $          | (4.79    | )          | $        | (1.81      | )        | $          | (0.97 | ) | $ | (0.63 | ) |

 

22

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| ** **                       | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| **Balance Sheet Data:**          |       |     |       |     |       |     |       |     |       |     |       |
| Working capital  (deficit)       |       | $        | (885       | )        | $          | (828     | )          | $        | (1,187     | )        | $          | 1,820 |   | $ | 701 |   |
| Total assets                     |       | 7,012    |       | 4,373    |       | 4,864    |       | 7,119    |       | 5,478    |       |
| Total liabilities                |       | 4,198    |       | 2,725    |       | 2,828    |       | 2,274    |       | 2,817    |       |
| Accumulated  deficit             |       | (77,060  | )          | (84,207  | )          | (90,393  | )          | (96,972  | )          | (102,852 | )          |
| Total stockholders’  equity |       | 2,814    |       | 1,648    |       | 2,035    |       | 4,845    |       | 2,661    |       |
|                                  |            |          |            |          |            |          |            |          |            |          |            |  |  |  |  |  |

 

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

**Item 7.**                        Management’s Discussion and Analysis of FinancialCondition and Results of Operations.

The following discussionof financial condition and results of operations should be read in conjunctionwith VCampus’ consolidated financial statements and related notes theretoincluded elsewhere in this report.

**Overview**

Our revenues arederived from two primary sources:

·       onlinetuition revenues; and

·       developmentand other revenues;

Online tuition revenuesare generated primarily from online tuition derived from corporate, governmentand association customers and sales of our Select Partner courseware.Development and other revenues consist primarily of fees paid to us forcreating and developing new online courseware and web-enabling existingcourseware.

**CriticalAccounting Policies and Estimates**

Our critical accountingpolicies are more fully described in note 2 to our consolidated financialstatements included in this Annual Report on Form 10-K. Certain ofour accounting policies require the application of significant judgment bymanagement in selecting the appropriate assumptions for calculating financialestimates. By their nature, these judgments are subject to an inherent degreeof uncertainty. These judgments are based on practices, information provided byour customers and other assumptions that we believe are reasonable under thecircumstances. Our estimates and assumptions are reviewed periodically and theeffects of revisions are reflected in the consolidated financial statements inthe period in which they are determined to be necessary. Actual results maydiffer from these estimates under different assumptions or conditions. Ourcritical accounting policies and estimates include:

*Revenue Recognition*

We derive our revenues from the following sources—onlinetuition revenues and development and other revenues.

Online tuition revenue is recognized in accordancewith SEC Staff Accounting Bulletin No. 104, *Revenue Recognition* (SAB 104). SAB 104 generally requiresthat four basic criteria must be met before revenue can be recognized: (1) persuasiveevidence of an arrangement exists; (2) delivery has occurred or servicesrendered; (3) the fee is fixed and determinable: and (4) collectibilityis reasonably assured. Determination of criteria (3) and (4) arebased on management’s judgments regarding the fixed nature of the fee chargedfor services rendered and the collectibility of those fees. Should changes inconditions cause management to determine these criteria are not met for certainsales, revenue recognized for any 

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reporting period could beadversely affected. Online tuition revenues are generated primarily throughthree types of contracts: (i) corporate subscriptions, (ii) contractswith Select Partners and (iii) corporate usage. Under corporatesubscriptions and Select Partner contracts, revenue is recognized ratably (on astraight-line basis) over the subscription period. For usage contracts, revenueis recognized upon enrollment in a course. Once a student has enrolled in acourse, he generally cannot cancel delivery of a course or receive a refund. Onrare occasions, we may extend the subscription length for a specific student’scourse at no charge. Initial set-up fees related to all online tuition servicesare recognized ratably (on a straight-line basis) over the contract term.

Development and other revenues consist primarily offees paid to us for developing and converting courseware. For arrangements thatinclude more than one element, we allocate the total arrangement fee among eachdeliverable based on vendor-specific objective evidence (“VSOE”) of therelative fair value of each deliverable. VSOE is determined using the pricecharged when that element is sold separately by us. Development and otherrevenues earned under courseware conversion contracts are recognized relativeto our proportionate performance based on the ratio that total costs incurredto-date bear to total estimated costs. We use direct labor hours as the keycriteria to measure progress towards completion. We develop our estimates tocomplete based on budgeted total costs and periodic assessment by our projectmanagers.

We sometimes recognize development and other revenuesas a separate element of an arrangement with a customer that also contains anelement to provide courseware delivery services. The SEC Staff believes thatthe best indicator that a separate element exists is that a vendor sells orcould readily sell that element unaccompanied by other elements. We have ahistory of selling courseware development and conversion services unaccompaniedby other elements. Further, EITF 00-21 (“Revenue Arrangements withMultiple Deliverables”), states that a deliverable should be segmented andaccounted for separately from the remainder of the arrangement if: (1) thereis objective and reliable evidence of the fair value of the element and (2) theelement does not affect the quality of use or the value of the other elementsand the element can be purchased from an unrelated vendor without effecting thequality of use or value of the other elements. We believe that the hourly ratescharged for development revenues are consistent and represent the fair value ofthese services.

In most cases, developmentprojects are requested after delivery of online tuition services has begun(i.e. no development work was considered when terms of the online tuitionagreement were negotiated). We have demonstrated the ability for our developedand converted material to be used in absence of our platform. In addition,customers can use other vendors to develop electronic course material ordevelop course material internally for use on our platform. Accordingly, webelieve that separate recognition of development revenues for customers whohave online tuition contracts is appropriate.

*Allowance forDoubtful Accounts*

We maintain allowances fordoubtful accounts for estimated losses resulting from the inability of ourcustomers to make required payments. If the financial condition of thosecustomers were to deteriorate, resulting in an impairment of their ability tomake payments, additional allowances may be required in future periods.

*CapitalizedSoftware and Courseware Development Costs*

We capitalize costs associated with internallydeveloped software in accordance with Statement of Position 98-1, “Accountingfor the Costs of Computer Software Developed or Obtained for Internal Use” (SOP98-1). SOP 98-1 provides guidance for the treatment of costsassociated with computer software development and defines those costs to becapitalized and those to be expensed. Costs that qualify for capitalization areexternal direct costs, payroll, payroll-related costs, and interest costs. Costsrelated to general and administrative functions are not capitalizable and areexpensed as incurred. We capitalize 

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software and coursewaredevelopment costs when the projects under development reach technologicalfeasibility. Many of our new courses leverage off of proven delivery platformsand are primarily content, which has no technological hurdles. As a result, asignificant portion of our courseware development costs qualify forcapitalization due to the concentration of our development efforts on thecontent of the courseware. Technological feasibility is established when wehave completed all planning, designing, coding, and testing activitiesnecessary to establish that a course can be produced to meet its designspecifications. Capitalization ends when a course is available for generalrelease to our customers, at which time amortization of the capitalized costsbegins. Amortization of such costs is based on the greater of (1) theratio of current gross revenues to the sum of current and anticipated grossrevenues, or (2) the straight-line method over the remaining economic lifeof the vcampus or courseware, typically two to three years. It is possible thatthose anticipated gross revenues, the remaining economic life of the products,or both, may be reduced as a result of future events.

We evaluate capitalized software costs in accordancewith the provisions of Statement of Financial Accounting Standards No. 144“Accounting for the Impairment or Disposal of Long-Lived Assets (as amended)”.In assessing whether there is an impairment issue with respect to capitalizedsoftware costs, we determined that there is no reliable basis for estimatingfuture gross revenues related to our capitalized software. However, ourcapitalized software is expected to continue operations well into the future. Asit represents a majority of our business, we do not expect the revenue streamrelating to online courses to end and, accordingly, we will continue to makemodifications in order for our capitalized software to remain viable. Inestimating future expected cash flows (i.e. inflows less outflows) we usehistorical cash flows that are directly associated with the online tuitionrevenue and an estimate of the outflows that are expected to arise as a directresult of the use and eventual disposition of the asset.

We evaluate capitalized courseware development costsat least annually or more frequently if events or changes in circumstancesindicate that the asset might be impaired, to determine if the unamortizedbalance related to any given course exceeds the estimated net realizable valueof that course. Estimating net realizable value requires us to estimate futurerevenues and cash flows to be generated by the course and to use judgment inquantifying the amount, if any, to be written off. We consider coursewaredevelopment costs impaired when the carrying amount is not recoverable andexceeds the asset’s fair value. The carrying amount is deemed unrecoverable ifit is greater than the sum of undiscounted cash flows expected to result formuse and eventual disposition of the asset. We recognize an impairment chargeequal to the excess of the carrying amount over the fair value of the asset.

In estimating future cashflows (i.e., inflows less outflows) we use only those directly associated withthe use and ultimate disposition of the underlying asset. In estimating futurecash flows to test for recoverability we take all available evidence into accountbased on our planned usage of the underlying asset and use assumptionsconsistent with those used to develop other information (i.e., internalprojections, forecasts, and budgets). The period over which cash flows areprojected is based on the remaining useful life of the underlying asset. As aresult of our analysis, we recorded provisions for impairment relating tocapitalized courseware development costs.

*Goodwill and OtherIdentifiable Intangibles*

Management assesses the recoverability of goodwill andother identifiable intangibles whenever events or changes in circumstancesindicate that the carrying value may not be recoverable. When managementdetermines that the carrying value of goodwill or other identifiableintangibles is not recoverable, an impairment loss is recognized to the extentthe carrying value of the asset exceeds its fair value. Fair value can beestimated using a number of techniques including quoted market prices,valuations by third parties and discounted cash flow analysis. The fair valueof the asset could be different using different estimates and assumptions inthese valuation techniques.

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In accordance withStatement of Financial Accounting Standards No. 142, “Goodwill and OtherIntangibles,” goodwill and other indefinite-lived intangibles are subjectto an annual impairment review. We may determine through the impairment reviewprocess that goodwill or other indefinite-lived intangibles have beenimpaired, resulting in an impairment charge in the period the review iscompleted.

*Derivativefinancial instruments*

We do not use derivative instruments to hedgeexposures to cash flow, market, or foreign currency risks.

We review the terms of convertible debt and equityinstruments that we issue to determine whether there are embedded derivativeinstruments, including the embedded conversion option, that are required to bebifurcated and accounted for separately as a derivative financial instrument.When the risks and rewards of any embedded derivative instrument are not “clearlyand closely” related to the risks and rewards of the host instrument, theembedded derivative instrument is generally required to be bifurcated andaccounted for separately. If the convertible instrument is debt, or hasdebt-like characteristics, the risks and rewards associated with the embeddedconversion option are not “clearly and closely” related to that debt host instrument.The conversion option has the risks and rewards associated with an equityinstrument, not a debt instrument, because its value is related to the value ofour common stock. Nonetheless, if the host instrument is considered to be “conventionalconvertible debt” (or “conventional convertible preferred stock”), bifurcationof the embedded conversion option is generally not required. However, if theinstrument is not considered to be conventional convertible debt (orconventional convertible preferred stock), bifurcation of the embeddedconversion option may be required in certain circumstances. Generally, wherethe ability to physical or net-share settle the conversion option is deemed tobe not within the control of us, the embedded conversion option is required tobe bifurcated and accounted for as a derivative financial instrument liability.

In connection with the sale of convertible debt andequity instruments, we may also issue freestanding options or warrants.Additionally, we may issue options or warrants to non-employees in connectionwith consulting or other services they provide. Although the terms of theoptions and warrants may not provide for net-cash settlement, in certaincircumstances, physical or net-share settlement may be deemed to not be withinthe control of the us and, accordingly, we may be required to account for thesefreestanding options and warrants as derivative financial instrumentliabilities, rather than as equity.

Derivative financial instruments are required to beinitially measured at their fair value. For derivative financial instrumentsthat shall be accounted for as liabilities, the derivative instrument isinitially recorded at its fair value and is then re-valued at each reportingdate, with changes in the fair value reported as charges or credits to income.

In circumstances where the embedded conversion optionin a convertible instrument may be required to be bifurcated and there are alsoother embedded derivative instruments in the convertible instrument that arerequired to be bifurcated, the bifurcated derivative instruments are accountedfor as a single, compound derivative instrument.

If the embedded derivative instrument is to bebifurcated and accounted for as a liability, the total proceeds received willbe first allocated to the fair value of the bifurcated derivative instrument.If freestanding options or warrants were also issued and are to be accountedfor as derivative instrument liabilities (rather than as equity), the proceedsare next allocated to the fair value of those instruments. The remainingproceeds, if any, are then allocated to the convertible instrument itself,usually resulting in that instrument being recorded at a discount from its faceamount. In circumstances where a freestanding derivative instrument is to beaccounted for as an equity instrument, the proceeds are allocated between theconvertible instrument and the derivative equity instrument, based on theirrelative fair values.

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To the extent that the fair values of the bifurcatedand/or freestanding derivative instrument liabilities exceed the total proceedsreceived, an immediate charge to income is required to be recognized, in orderto initially record the derivative instrument liabilities at their fair value.The discount from the face value of the convertible debt instrument is requiredto be amortized over the life of the instrument through periodic charges toincome, using the effective interest method. When the instrument is convertiblepreferred stock, the periodic amortization of the discount is charged directlyto retained earnings.

We review theclassification of derivative instruments, including whether such instrumentsshould be recorded as liabilities or as equity, at the end of each reportingperiod. Derivative instrument liabilities are required to be classified in thebalance sheet as current or non-current based on whether or not net-cashsettlement of the derivative instrument could be required within 12 months ofthe balance sheet date. We currently do not have any derivative instrumentsthat are required to be bifurcated and recorded as liabilities.

**Results of Operations**

Thefollowing table sets forth certain statement of operations data as a percentageof total net revenues for the periods indicated:

| ** **                                                                        | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** |
|-----------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Statement of  Operations Data:                                                    |       |     |       |     |       |     |       |
| Revenues:                                                                         |       |     |       |     |       |     |       |
| Online tuition revenues                                                           |       | 90.8     | %          | 92.5     | %          | 88.6     | %          |
| Development and other revenues                                                    |       | 7.4      |       | 6.5      |       | 11.4     |       |
| Other service revenues                                                            |       | 1.8      |       | 1.0      |       | 0.0      |       |
| Total net revenues                                                                |       | 100.0    |       | 100.0    |       | 100.0    |       |
| Costs and  expenses:                                                              |       |     |       |     |       |     |       |
| Cost of revenues                                                                  |       | 28.3     |       | 27.9     |       | 37.9     |       |
| Sales and marketing                                                               |       | 35.2     |       | 39.0     |       | 37.8     |       |
| Product development and operations                                                |       | 40.8     |       | 56.0     |       | 58.0     |       |
| General and administrative                                                        |       | 31.5     |       | 34.7     |       | 32.6     |       |
| Depreciation and amortization                                                     |       | 14.5     |       | 25.2     |       | 34.5     |       |
| Reorganization and other non-recurring charges  and stock based compensation |       | 5.0      |       | 3.2      |       | 2.4      |       |
| Total costs and  expenses                                                         |       | 155.3    |       | 186.0    |       | 203.2    |       |
| Loss from  operations                                                             |       | (55.3    | )          | (86.0    | )          | (103.2   | )          |
| Other income  (expense):                                                          |       |     |       |     |       |     |       |
| Other income                                                                      |       | 3.4      |       | 3.8      |       | 0.0      |       |
| Interest expense                                                                  |       | (1.8     | )          | (53.1    | )          | (25.3    | )          |
| Net loss                                                                          |       | (53.7    | )%         | (135.3   | )%         | (128.5   | )%         |

 

*2005 Compared to2004*

*Summary*

We incurred a net loss attributable to commonstockholders of $5,880,639 (or $0.63 per share) in 2005 as compared to a netloss attributable to common stockholders of $6,579,416 (or $0.97 per share) in2004. The net loss for the twelve monthsended December 31, 2005 includes $1,060,057 of non-cash amortization ofdebt discount and debt offering costs. The net loss for the twelve months endedDecember 31, 2004 includes $2,430,849 of non-cash amortization of debtdiscount and debt offering costs and $183,210 of other income as a result ofsettlements with a customer and two vendors. The decrease in the netloss in 2005 as compared to 2004 was due primarily to a decrease in interestexpense and, to a lesser extent, 

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operating costs, whichwere partially offset by a 6% decrease in revenues and a 28% increase in costof revenues.

The following table setsforth selected financial data:

| ** **                                    | ** ** | **For the Year Ended December 31,** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                    | ** ** | **2004**                                                     | ** ** | **2005** | ** ** |
| Revenues                                      |       | $                                                            | 4,863,859  |   | 100.0 | % | $ | 4,564,463 |   | 100.0 | % |
| Cost of revenues                              |       | 1,356,699                                                    |       | 27.9 |   | 1,730,892 |   | 37.9 |   |
| Sales and  marketing                          |       | 1,895,340                                                    |       | 39.0 |   | 1,723,313 |   | 37.8 |   |
| Product  development and operations           |       | 2,725,155                                                    |       | 56.0 |   | 2,649,215 |   | 58.0 |   |
| General and  administrative                   |       | 1,686,940                                                    |       | 34.7 |   | 1,488,240 |   | 32.6 |   |
| Depreciation and  amortization                |       | 1,227,089                                                    |       | 25.2 |   | 1,574,242 |   | 34.5 |   |
| Stock-based  compensation                     |       | 153,973                                                      |       | 3.2 |   | 109,493 |   | 2.4 |   |
| Loss from  operations                         |       | (4,181,337                                                   | )          | (86.0 | ) | (4,710,932 | ) | (103.2 | ) |
| Other income                                  |       | 183,210                                                      |       | 3.8 |   | — |   | 0.0 |   |
| Interest expense                              |       | (2,581,289                                                   | )          | (53.1 | ) | (1,155,395 | ) | (25.3 | ) |
| Net loss                                      |       | (6,579,416                                                   | )          | (135.3 | ) | (5,866,327 | ) | (128.5 | ) |
| Dividends to  preferred stockholders          |       | —                                                       |       | 0.0 |   | (14,312 | ) | (0.3 | ) |
| Net loss attributable to  common stockholders |       | $                                                            | (6,579,416 | ) | (135.3 | )% | $ | (5,880,639 | ) | (128.8 | )% |

 

| ** **                             | ** ** | **For the Year Ended December 31,** | ** ** |
|----------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                             | ** ** | **2004**                                                     | ** ** | **2005** | ** ** |
| Online tuition  revenues               |       | $                                                            | 4,497,513  |   | 92.5 | % | $ | 4,045,979 |   | 88.6 | % |
| Online  development and other revenues |       | 318,456                                                      |       | 6.5 |   | 518,484 |   | 11.4 |   |
| Other service  revenues                |       | 47,890                                                       |       | 1.0 |   | — |   | 0.0 |   |
| Total net revenues                     |       | $                                                            | 4,863,859  |   | 100.0 | % | $ | 4,564,463 |   | 100.0 | % |

 

Online tuition revenues decreased 10.0% to $4,045,979in 2005, compared to $4,497,513 in 2004. The decrease is primarily due to adecrease in revenue from higher education customers (decrease of $1,220,000),and more specifically from Park University, which was partially offset byincreases in revenues from Select Partners, corporate and government customers(increases of $492,000, $265,000 and $11,000, respectively).

Online development and other revenues increased 62.8%to $518,484 in 2005, compared to $318,456 in 2004. The increase is primarilydue to an increase in course development and professional services ordersincluding a large courseware order from a Select Partner in 2005.

Other service revenueswere $47,890 for twelve months ended December 31, 2004. Our contract withthe U.S. Army, under which all licensing and support revenues were generated,was completed in May 2004. Accordingly, we ceased recognizing licensingand support revenues after that date.

*Cost of Revenues*

Cost of revenues increased 27.6% to $1,730,892 in 2005as compared to $1,356,699 in 2004. The increase is primarily due to the factthat as we continue to build our Select Partner courseware library, we replacedpart of the former Park University revenues with revenues from readilyavailable third-party content courses which carry royalty costs. The increaseis also due to the increase in costs associated with an increase in developmentand other revenues which increased in the twelve months ended December 31,2005 compared to the same period in 2004.

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Operating Expenses

*Salesand Marketing.**  *Salesand marketing expenses decreased 9.1% to $1,723,313 in 2005 compared to$1,895,340 in 2004. The decrease is primarily attributable to decreasedheadcount and related costs and, to a lesser extent, a decrease inout-of-pocket costs in sales and marketing in the twelve months ended December 31,2005 as we gain more experience in and streamline our marketing activitiesassociated with our Select Partner program.

*ProductDevelopment and Operations.**  *Product developmentand operations expenses decreased 2.8% to $2,649,215 in 2005 compared to$2,725,155 in 2004. The decrease isprimarily due to decreases in headcount and related costs as well asout-of-pocket costs. The decrease was partially offset by the fact that followingthe release of our new course management system in the first quarter of 2004,we did not capitalize any software development costs (due to their nature) inthe first quarter of 2005, whereas in the first quarter of 2004, softwaredevelopment costs had been capitalized.

*Generaland Administrative.**  *Generaland administrative expenses decreased 11.8% to $1,488,240 in 2005 as comparedto $1,686,940 in 2004. The decrease is primarily due to the payment ofincentive compensation amounts to employees in the second quarter of 2004 whichdid not occur in the 2005 period. The decrease was also due to reductions inlegal, accounting and other professional fees as well as other overhead costsdue to reductions in headcount and our efforts to monitor and reduce costswhere possible.

*Depreciationand Amortization.**  *Depreciationand amortization expense increased 28.3% to $1,574,242 in 2005 as compared to$1,227,089 in 2004. The increase is primarily due to the release of ourenhanced Course Management System in the first quarter of 2004 as a result ofwhich we began amortizing costs we had capitalized for its development, therelease of new Select Partner courses and the resulting amortization ofcapitalized costs incurred for their development and the write off or writedown of capitalized costs incurred for the development of nine courses duringthe 2005 period to their estimated net realizable value as a result ofimpairment analyses.

*Stock-basedCompensation.**  *Stock-based compensation expense for 2005 and2004 consists of the fair value of stock issued as customary payment to ournon-employee directors for their participation in Board of Directors and BoardCommittee meetings and the fair market value of stock issued to consultants. Undernew accounting standards that became effective on January 1, 2006, we mustrecord compensation expense in our financial statements for stock options andother equity-based awards granted to employees. Accordingly, we expect ourstock-based compensation expense to materially increase in future periods.

*InterestExpense.**  *Interest expense for 2005 and 2004 primarilyconsists of amortization of debt discount and deferred debt offering costs andinterest related to the $3,649,625 (as reduced to $1,385,390 followingmandatory and voluntary conversions and payments of principal through December 31,2005) of convertible promissory notes issued in March 2004.

*Other Income.**  *Other income for 2004 consists of amountsrecorded in connection with the settlements with Park University and two of ourcontent providers which resulted in the write-off of royalty obligations.

*2004 Compared to2003*

*Summary*

We incurred a net loss attributable to commonstockholders of $6,579,416 (or $0.97 per share) in 2004 as compared to a netloss attributable to common stockholders of $6,185,877 (or $1.81 per share) in2003. The increase in the net loss in 2004 as compared to 2003 was dueprimarily to a decrease in online tuition revenues and an increase in interestexpense, partially offset by the absence of dividends to preferred stockholdersin 2004 ($2,926,854 of such dividends were included in the net lossattributable to common 

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stockholders for 2003). Thedecrease in net loss per share for 2004 compared to 2003 was due to theissuance of additional shares in 2004.

The following table sets forth selected financialdata:

| ** **                                      | ** ** | **For the Year Ended December 31,** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                      | ** ** | **2003**                                                     | ** ** | **2004** | ** ** |
| Revenues                                        |       | $                                                            | 6,066,035  |   | 100.0 | % | $ | 4,863,859 |   | 100.0 | % |
| Cost of revenues                                |       | 1,718,340                                                    |       | 28.3 |   | 1,356,699 |   | 27.9 |   |
| Sales and  marketing                            |       | 2,137,791                                                    |       | 35.2 |   | 1,895,340 |   | 39.0 |   |
| Product  development and operations             |       | 2,474,856                                                    |       | 40.8 |   | 2,725,155 |   | 56.0 |   |
| General and  administrative                     |       | 1,909,814                                                    |       | 31.5 |   | 1,686,940 |   | 34.7 |   |
| Depreciation and  amortization                  |       | 879,966                                                      |       | 14.5 |   | 1,227,089 |   | 25.2 |   |
| Reorganization  and other non-recurring charges |       | 172,729                                                      |       | 2.9 |   | — |   | 0.0 |   |
| Stock-based  compensation                       |       | 126,056                                                      |       | 2.1 |   | 153,973 |   | 3.2 |   |
| Loss from  operations                           |       | (3,353,517                                                   | )          | (55.3 | ) | (4,181,337 | ) | (86.0 | ) |
| Other income                                    |       | 207,138                                                      |       | 3.4 |   | 183,210 |   | 3.8 |   |
| Interest expense                                |       | (112,644                                                     | )          | (1.8 | ) | (2,581,289 | ) | (53.1 | ) |
| Net loss                                        |       | (3,529,023                                                   | )          | (53.7 | ) | (6,579,416 | ) | (135.3 | ) |
| Dividends to  preferred stockholders            |       | (2,926,854                                                   | )          | (48.3 | ) | — |   | 0.0 |   |
| Net loss attributable to  common stockholders   |       | $                                                            | (6,185,877 | ) | (102.0 | )% | $ | (6,579,416 | ) | (135.3 | )% |

 

| ** **                             | ** ** | **For the Year Ended December 31,** | ** ** |
|----------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                             | ** ** | **2003**                                                     | ** ** | **2004** | ** ** |
| Online tuition  revenues               |       | $                                                            | 5,508,154  |   | 90.8 | % | $ | 4,497,513 |   | 92.5 | % |
| Online  development and other revenues |       | 448,082                                                      |       | 7.4 |   | 318,456 |   | 6.5 |   |
| Other service  revenues                |       | 109,799                                                      |       | 1.8 |   | 47,890 |   | 1.0 |   |
| Total net revenues                     |       | $                                                            | 6,066,035  |   | 100.0 | % | $ | 4,863,859 |   | 100.0 | % |

 

Online tuition revenues decreased 18.3% to $4,497,513in 2004, compared to $5,508,154 in 2003. The decrease is primarily due to adecrease in revenue from higher education customers, and more specifically fromPark University (decrease of $1,101,000) and corporate customers (decrease of$197,000), which was partially offset by an increase in revenue from governmentcustomers and Select Partners (increases of $101,000 and $187,000,respectively).

Online development and other revenues decreased 28.9%to $318,456 in 2004, compared to $448,082 in 2003. The decrease is primarilydue to a decline in course development and professional services orders. As wemove away from developing and hosting courses that are proprietary to ourcustomers to the co-development of courses under our Select Partner strategy,for which we typically do not charge our Select Partners development fees, weexpect development revenues to continue to remain a relatively small componentof our total revenues. However, we generally receive a relatively higher percentageof the revenue from the sale of Select Partner courses, in lieu of suchforegone development fees.

Other service revenuesdecreased 56.4% to $47,890 in 2004, compared to $109,799 in 2003. Our contractwith the U.S. Army, under which all licensing and support revenues weregenerated, was completed in May 2004. Accordingly, we stopped recognizinglicensing and support revenues under this contract following that date.

*Cost of Revenues*

Cost of revenues decreased 21.0% to $1,356,699 in 2004as compared to $1,718,340 in 2003. Thedecrease was primarily due to the sale of a higher percentage of courses withrelatively lower associated royalty costs.

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Operating Expenses

*Salesand Marketing.**  *Salesand marketing expenses decreased 11.3% to $1,895,340 in 2004 compared to$2,137,791 in 2003. Excluding the Park Development Fund contribution in 2003,which did not recur in 2004 as a result of the non-renewal of our contract withPark University in May 2004, sales and marketing expenses were $1,895,340and $1,762,035 for 2004 and 2003, respectively, an increase of 7.6%. Theincrease was primarily attributable to out-of-pocket costs in sales andmarketing associated with the implementation and support for our Select Partnerprogram in 2004.

*ProductDevelopment and Operations.**  *Product developmentand operations expenses increased 10.1% to $2,725,155 in 2004 compared to$2,474,856 in 2003. The increase was due tothe fact that following the release of our new course management system in thefirst quarter of 2004, we did not capitalize any software development costs(due to their nature) in the last three quarters of 2004, whereas in 2003,software development costs had been capitalized.

*Generaland Administrative.**  *Generaland administrative expenses decreased 11.7% to $1,686,940 in 2004 as comparedto $1,909,814 in 2003. The decrease was primarily due to the expiration of theemployment agreement and related termination of employment of our Vice Chairmanin December 2003 and the absence (in 2004) of legal and accounting costsincurred in 2003 associated with the SEC review, in the ordinary course, of thecompany’s public filings.

*Depreciationand Amortization.**  *Depreciationand amortization expense increased 39.4% to $1,227,089 in 2004 as compared to$879,966 in 2003. The increase was primarily due to the release of our newCourse Management System in the first quarter of 2004, as well as the releaseof a number of Select Partner courses, as a result of which we began amortizingcosts we had capitalized for their development.

*Reorganizationand Other Charges.**  *Reorganizationand other charges of $172,729 in 2003 consist of amounts paid in excess ofprior accruals to satisfy in full all liabilities in connection with thetermination of the Rockville, Maryland facility lease and our other recentlegal settlements.

*Stock-basedCompensation.**  *Stock-based compensation expense for 2004 and2003 consists of the fair value of stock issued as customary payment to ournon-employee directors for their participation in Board of Directors and BoardCommittee meetings and the fair market value of stock issued to consultants.

*InterestExpense.**  *Interest expense for 2003 primarily consists ofamortization of debt discount and deferred debt offering costs related to theremaining balance of the $925,000 of convertible promissory notes issued in December 2001.Interest expense for 2004 primarily consists of amortization of debt discountand deferred debt offering costs and accrual of interest payable related to the$3,649,625 ($2,137,500 following mandatory and voluntary partial conversions inthe second, third and fourth quarters of 2004) of convertible promissory notesissued in March 2004.

*Other Income.**  *Other income for 2003 consists of the write-offof royalty obligations to one of our former content providers following theexpiration of the relevant statute of limitations for bringing any action toenforce the obligations. Other income for 2004 consists of amounts recorded inconnection with the settlements with Park University and two of our contentproviders which resulted in the write-off of royalty obligations.

**Liquidity and Capital Resources**

At December 31, 2005, we had $2,488,159 in cashand cash equivalents, compared to $2,632,504 at December 31, 2004. Thedecrease in cash and cash equivalents during 2005 is principally due the netloss recorded as reduced by cash raised in the March 2005 common stock andDecember 2005 preferred stock financings. Since our inception, we havefinanced our operating cash flow needs primarily through offerings of equityand debt securities and, to a lesser extent, borrowings. Cash utilized inoperating 

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activities was $2,188,886in 2005 and $3,408,927 in 2004. The decrease in cash utilized in operatingactivities is primarily due to the paydown of accounts payable balances in the2004 period following our March 2004 private placement, partially offsetby an increase in our accounts payable from $575,183 at December 31, 2004to $1,182,585 at December 31, 2005 which was mainly due to the timing ofpayments for certain large payables.

Cash utilized in investing activities was $678,464 in2005 and $1,127,333 in 2004. The use of cash for investing activities in bothperiods is primarily attributable to courseware development costs that werecapitalized and the purchase of computer equipment as we continue to maintainand upgrade our technological infrastructure. The use of cash for investingactivities for twelve months ended December 31, 2004 was also attributableto software development costs that were capitalized. The decrease in cashutilized in investing activities is primarily due to the fact that for thetwelve months ended December 31, 2004, we had capitalized $329,347 ofsoftware development costs whereas, due to their nature, we fully expensed suchcosts in the 2005 period, and therefore, they were not included in cashutilized in investing activities in the 2005 period.

Cash provided by financing activities was $2,723,005in 2005 and $6,633,780 in 2004.

In March 2005, we completed a private placementof our common stock. Under the terms of this private placement, we raised$995,950 in gross proceeds through the issuance of 611,012 shares of common stockat a purchase price of $1.63 per share. Under the terms of this financing, wealso issued five-year warrants to purchase 763,765 shares of common stock withan exercise price of $1.63 per share.

In December 2005, we completed a privateplacement of Series A-1 convertible Preferred Stock. Under the termsof this financing, we raised $2,300,000 in gross proceeds through the issuanceof 2,300 shares of Series A-1convertible Preferred Stock at a purchase price of $1,000 per share toaccredited investors. Under the terms of this financing, we also issuedwarrants to purchase 1,032,929 shares of common stock to the same accreditedinvestors at an exercise price per share equal to the then applicableconversion price of the Series A-1 Preferred Stock. The shares of Series A-1Preferred Stock are initially convertible into common stock at a conversionprice of $1.67 per share. The conversion price is subject to a price reset on March 31,2006 to equal $0.61 per share in the event that before March 31, 2006 thecommon stock does not trade at or above $6.00 per share for at least tenconsecutive trading days after the shares of common stock issued or issuable inthe financing have been registered for resale under a registration statementdeclared effective by the SEC. The conversion price is subject to furtheradjustment to $0.50 per share upon shareholder approval of the Series A-1Preferred Stock financing. We intend to solicit shareholder approval for thefinancing at our 2006 annual meeting scheduled for May 2006. The exerciseprice of the warrants and the number of shares issuable thereunder are subjectto adjustment upon any change to the conversion price of the Series A-1Preferred Stock.

In March 2006, we completed a private placementof Series B-1 convertible Preferred Stock. Under the terms of thisfinancing, we raised $2,300,000 in gross proceeds through the issuance of 2,300shares of Series B-1 convertiblePreferred Stock at a purchase price of $1,000 per share to two accreditedinvestors, one of whom is Barry Fingerhut, our largest beneficial stockholder. Underthe terms of this financing, we also issued ten-year warrants to purchase1,000,000 shares of common stock to the same accredited investors at anexercise price per share equal to the then applicable conversion price of the Series B-1Preferred Stock. The warrants are firstexercisable commencing four years from their issuance date. Beginning threeyears from their date of issuance, the shares of Series B-1Preferred Stock are convertible, at the option of their holders, into commonstock based on a formula that yields a discount of between 10% and37.5% to the last closing bid price of the common stock priorto the date of conversion, subject to a price floor of $1.64 per share. Theshares of Series B-1 Preferred Stock are entitled toreceive dividends paid quarterly at the greater of: (a) an annualrate of 16%, or (b) 6% of the net sales proceeds from two courses to bemutually agreed upon by the parties. Each share of Series B-1Preferred Stock has a 

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liquidation preferenceequal to 150% of the purchase price paid for the share. The shares ofSeries B-1 Preferred Stock are non-voting. We intend to solicitshareholder approval for the financing at our 2006 annual meetingscheduled for May 2006. The proceeds are intended to be used for generalcorporate purposes.

We have incurred significant losses since inceptionand had an accumulated deficit of $102.9 million as of December 31,2005. We expect negative cash flow from operations to continue until our SelectPartner business model matures. Management’s plans to address these conditionsinclude pursuing additional capital and continued focus on increasing sales tonew customers through the Select Partner program, which have partially replacedthe sales related to the large legacy customer lost in 2004. Management anticipatesthe increase in sales experienced in 2005 under the Select Partner programto continue into 2006. Management has also instituted cost cutting measures andoperates under an approved budget, which is closely monitored. However, in theevent revenues do not meet anticipated levels or we are unable to raiseadditional funding to meet working capital requirements, we may need to furthersignificantly reduce operating expenses which might in turn impact our abilityto meet projected sales levels.

We have an obligation to repay principal and interestunder our convertible notes that began in July 2005. The total outstandingprincipal remaining under these convertible notes as of December 31, 2005amounted to $1,385,390. Cash payments for principal under these notes areapproximately $99,000 per quarter through the maturity date in April 2009,unless such notes are sooner converted to common stock or restructured. Initialcash payments for interest under these notes are approximately $36,000 perquarter beginning July 1, 2005 and will gradually be reduced as theprincipal is paid down. We made our first three installments of principal andinterest in July and October 2005 and January 2006 and the nextinstallment is due in April 2006. In February 2006, holders of amajority of these notes notified us that they believe an event of defaultexists under the notes based on our failure to acknowledge their alleged rightto have the conversion price on their notes reduced from $1.63 per share to$0.50 per share, which is the lowest potential reset conversion price for the Series A-1Preferred Stock we issued to other investors in the December 2005financing. We dispute the claims made by the note holders for a number ofreasons, including the fact that their antidilution rights expire, pursuant tothe express terms of the notes and warrants, prior to the price reset date on March 31,2006, and hence they expire prior to the happening of the alleged event orcontingency that might otherwise trigger their rights. Consequently, we believethe note holders’ allegations are without merit. Although we firmly believe noevent of default has occurred, we intend to pursue negotiations with the noteholders in an effort to reach an amicable resolution of the matter. If we areunable to resolve the dispute and in the event the note holders were successfulin pursuing their claims, they would thereafter be entitled to formally declarea default and immediately accelerate the entire amount of the indebtedness andpursue their rights as the senior secured creditor with respect to our assets. Thenote holders would also be entitled to any other remedies they might haveavailable under the notes and applicable law, including money damages and/orconversion of their indebtedness and exercise their warrants for shares ofcommon stock at the reduced price (which, in any event, should be no lower than$0.61, instead of $0.50). The note holders hold warrants for the purchase of978,533 shares of common stock.

We are obligated to pay a quarterly dividends at anannual rate of 10% on the Series A-1 Preferred Stock so long as itis outstanding. Based on the 2,342 shares of Series A-1 PreferredStock that were issued and remain outstanding through the date of this report,we are obligated to pay $234,200 per year in dividends to our PreferredStockholders.

We are obligated to pay dividends to our Series B-1Preferred Stockholders so long as the Series B-1 Preferred Stock isoutstanding. Dividends are due quarterly at the greater of: (a) an annualrate of 16%, or (b) 6% of the net sales proceeds from two courses to bemutually agreed upon by the parties.

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If we are not able to address our funding needs andrepayment obligations or if we were not successful in defending against orsettling the claims of default under our outstanding notes, we could bematerially adversely affected. Our future capital requirements will depend onmany factors, including, but not limited to, acceptance of and demand for ourproducts and services including the Select Partner business model, capitalrequirements associated with our acquisition plans, market demands fortechnology upgrades, possible restructuring or early repayment of ourindebtedness, the types of arrangements that we may enter into with customersand agents, and the extent to which the we invest in Select Partner coursewaredevelopment, new technology and research and development projects. While webelieve we have the ability to raise additional capital, our ability to raisecapital in the near term is uncertain. If we are unable to raise additionalfunding to meet working capital requirements and if the bid price of our commonstock does not close at or above $1.00 for a minimum of ten consecutivebusiness days, we may also be unable to meet Nasdaq Capital Market listingrequirements and we might not be able to achieve our business objectives. VCampusbelieves it has available capital on hand and sources for additional debt andequity capital in amounts necessary to meet its cash needs in 2006. However,additional capital, if needed and available, may not have terms favorable to usor our current stockholders.

As of December 31,2005, we had net operating loss carryforwards of approximately $69.7 millionfor federal income tax purposes, which will expire at various dates through2025. Our ability to utilize all of our net operating loss and creditcarryforwards may be limited by changes in ownership. Specifically, managementbelieves that deemed changes in ownership resulting from our recent equityfinancings will likely prevent us from using part or all of the net operatinglosses and credit carryfowards under the IRS change in ownership rules. We haverecognized a full valuation allowance against these deferred tax assets becausewe have determined that it is more likely than not that sufficient taxableincome will not be generated during the carryforward period available under thetax law to utilize the deferred tax assets.

*ContractualObligations*

Our future liquidity and capital resources will beaffected by our contractual obligations. Our significant contractualobligations as of December 31, 2005 are for debt and operating leases.These obligations are summarized as follows:

| ** **                       | ** ** | **Payments Due by Period** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations** | ** ** | ** **                                | ** ** | **Total** | ** ** | **2006** | ** ** | **2007 – 2009** | ** ** | **2010 – 2012** | ** ** | **2013 and  Thereafter** | ** ** |
| Notes payable(1)                 |       | $                                         | 1,385,390  |   | $ | 395,826 |   | $ | 989,564 |   |   | $ | — |   |   |   | $ | — |   |   |
| Operating leases                 |       | 2,361,381                                 |       | 540,778 |   | 1,721,635 |   |   | 98,968 |   |   |   | — |   |   |
| Total contractual  obligations   |       | $                                         | 3,746,771  |   | $ | 936,604 |   | $ | 2,711,199 |   |   | $ | 98,968 |   |   |   | $ | — |   |   |
|                                  |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          InMarch 2004, we raised $5,000,000 in gross cash proceeds through theprivate placement of 20 units, at a purchase price of $200,000 per unit, and Series Bsenior secured convertible notes in the aggregate principal amount of$1,000,000. Each unit consisted of 50,000 shares of common stock (initiallypriced at $1.63 per share), a Series A senior secured convertible note inthe original principal amount of $118,500 and a five-year warrant topurchase 61,350 shares of common stock. We issued an additional $250,000 of Series Bsenior secured notes in exchange for cancellation of existing short-termindebtedness in that amount. Upon approval of the private placement by VCampus’stockholders at our annual meeting in May 2004, $18,500 of principal of each ofthe Series A notes was converted into common stock at $1.63 per share and$100,000, or 50%, in principal of each of the Series B notes was convertedinto common stock at $1.63 per share. The total principal amount for both Series convertedupon approval of the stockholders was $999,625. Therefore, followingstockholder approval, a total of $2,650,000 of the placement was recorded asequity and $2,650,000 as senior debt. The notes mature in April 2009 and bearinterest at the rate of 8% per annum payable quarterly in cash or stock (valuedat the conversion price) at our option for the first year. Principal 

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and interest on thenotes are payable in cash over the following four years in quarterlyinstallments. During 2004, an additional $512,500 of Series A and Series Bsenior secured convertible note principal was converted into 314,420 shares ofcommon stock, resulting in $1,512,125 of aggregate principal from thisfinancing converted as of the end of 2004. During 2005, an additional $541,809of Series A and Series B senior secured convertible note principalwas converted into 332,398 shares of common stock, resulting in $2,053,934 ofaggregate principal from this financing converted as of the end of 2005.

*Recent Accounting Pronouncements*

In December 2004, FASB issued SFAS No. 123(revised 2004), “Share-Based Payment”, or SFAS 123(R), which is a revision ofSFAS No. 123 “Accounting for Stock-Based Compensation” (as amended) andsupersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”.Generally the approach in SFAS 123(R) is similar to the approachdescribed in SFAS No. 123. However, SFAS 123(R) requires allshare-based payments to employees, including grants of employee stock options,to be recognized in the income statement based on their fair values. Pro formadisclosure is no longer an alternative upon adopting SFAS 123(R).

We adopted SFAS 123(R) on January 1, 2006.SFAS 123(R) permits public companies to adopt its requirements using oneof two methods:

The “modified prospective” method in whichcompensation cost is recognized beginning with the effective date (a) basedon the requirements of SFAS 123(R) for all share-based payments grantedafter the effective date and (b) based on the requirements of SFAS 123(R) forall awards granted to employees prior to the effective date of SFAS 123(R) thatremain unvested on the effective date; or

The “modified retrospective” method which includes therequirements of the modified prospective method described above, but alsopermits entities to restate based on the amounts previously recognized underSFAS 123(R) for purposes of pro forma disclosures either (a) allprior periods presented or (b) prior interim periods of the year ofadoption.

We will implement SFAS 123(R) in the firstquarter of 2006 and intend to use the “modified prospective method”. We believethe pro forma disclosures in note 2, “Summary of Significant AccountingPolicies,” of the consolidated financial statements under the sub-heading “Stock-BasedCompensation” provide an appropriate short-term indicator of the level ofexpense that will be recognized in accordance with SFAS 123(R) for stockoptions granted prior to January 1, 2006 plus the expense related to stockoptions granted during 2006. The expense for stock options granted during 2006cannot be determined at this time due to the uncertainty of our stock price,the related Black-Scholes fair value and the timing of future grants.

In June 2005, the FASB ratified EITF Issue No. 05-2,“The Meaning of ‘Conventional Convertible Debt Instrument’ in EITF Issue No. 00-19,‘Accounting for Derivative Financial Instruments Indexed to, and PotentiallySettled in a Company’s Own Stock’ ” (“EITF No. 05-2”),which addresses when a convertible debt instrument should be considered “conventional”for the purpose of applying the guidance in EITF No. 00-19. EITF No. 05-2also retained the exemption under EITF No. 00-19 for conventionalconvertible debt instruments and indicated that convertible preferred stockhaving a mandatory redemption date may qualify for the exemption provided underEITF No. 00-19 for conventional convertible debt if the instrument’seconomic characteristics are more similar to debt than equity. EITF No. 05-2is effective for new instruments entered into and instruments modified inperiods beginning after June 29, 2005. We have applied the requirements ofEITF No. 05-2 since the required implementation date.

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In September 2005, the FASB ratified thefollowing consensus reached in EITF Issue 05-8 (“Income Tax Consequencesof Issuing Convertible Debt with a Beneficial Conversion Feature”): a) theissuance of convertible debt with a beneficial conversion feature results in abasis difference in applying FASB Statement of Financial Accounting StandardsSFAS No. 109, Accounting for Income Taxes. Recognition of such a featureeffectively creates a debt instrument and a separate equity instrument for bookpurposes, whereas the convertible debt is treated entirely as a debt instrumentfor income tax purposes. b) the resulting basis difference should be deemed atemporary difference because it will result in a taxable amount when therecorded amount of the liability is recovered or settled. c) recognition ofdeferred taxes for the temporary difference should be reported as an adjustmentto additional paid-in capital. This consensus is effective in the first interimor annual reporting period commencing after December 15, 2005, with earlyapplication permitted. The effect of applying the consensus should be accountedfor retroactively to all debt instruments containing a beneficial conversionfeature that are subject to EITF Issue 00-27, “Application of Issue No. 98-5to Certain Convertible Debt Instruments” (and thus is applicable to debtinstruments converted or extinguished in prior periods but which are stillpresented in the financial statements). The adoption of this pronouncement isnot expected to have a material impact on our consolidated financialstatements.

In February 2006, the FASB issued SFAS No. 155,“Accounting for Certain Hybrid Financial Instruments”. This Statement amendsFASB Statements No. 133, Accounting for Derivative Instruments and HedgingActivities, and No. 140, Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities.  This Statement resolves issues addressed inStatement 133 Implementation Issue No. D1, “Application of Statement 133to Beneficial Interests in Securitized Financial Assets.” SFAS No. 155permits fair value remeasurement for any hybrid financial instrument thatcontains an embedded derivative that otherwise would require bifurcation,clarifies which interest-only strips and principal-only strips are not subjectto the requirements of Statement 133, and establishes a requirement to evaluateinterests in securitized financial assets to identify interests that arefreestanding derivatives or that are hybrid financial instruments that containan embedded derivative requiring bifurcation. It also clarifies thatconcentrations of credit risk in the form of subordination are not embeddedderivatives and amends Statement 140 to eliminate the prohibition on aqualifying special-purpose entity from holding a derivative financial instrumentthat pertains to a beneficial interest other than another derivative financialinstrument. This Statement is effective for all financial instruments acquiredor issued after the beginning of an entity’s first fiscal year that beginsafter September 15, 2006. The Company has not yet determined the impact ofthe adoption of FAS 155 on its financial statements, if any.

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**Item 7A.**                Quantitative and Qualitative Disclosures AboutMarket Risk.

Our exposure to marketrisk for changes in interest rates is currently very minimal and relatesprimarily to any investments we may hold at various times. When investing, ourpurchases consist of highly liquid investments with maturities at the date ofpurchase generally no greater than 90 days and rarely ever more than twelvemonths, thus, due to the short-term nature of such investments and our usualintention to hold these investments until maturity, the impact of interest ratechanges would not have a material impact on our results of operations. Inaddition, essentially all of our debt obligations are at fixed interest rates.Given the fixed rate nature of the debt, the impact of interest rate changesalso would not have a material impact on our results of operations.  We are not currently exposed to any materialcurrency translation risks.

**Item 8.**                        Financial Statements and Supplementary Data.

The information requiredby this item is included in this Report at pages F-1 through F-35.See Index to Consolidated Financial Statements on page F-1.

**Item 9.**                     Changes In and Disagreements With Accountants onAccounting and Financial Disclosure.

Not applicable.

**Item 9A.**                Controls and Procedures.

(a)*  **Disclosure Controls and Procedures:*   Disclosurecontrols and procedures (as defined in Exchange Act Rule 13a-15(e))are designed only to provide reasonable assurance that they will meet theirobjectives. As of the end of the period covered by this report, the Companycarried out an evaluation, under the supervision and with the participation ofthe Company’s management, including the Company’s Chief Executive Officer andChief Financial Officer, of the effectiveness of the Company’s disclosurecontrols and procedures pursuant to Exchange Act Rule 13a-15. Basedupon that evaluation, the Company’s Chief Executive Officer and Chief FinancialOfficer have concluded that the Company’s disclosure controls and proceduresare effective to provide the reasonable assurance discussed above.

(b)*  **Internal Control Over FinancialReporting:*   No change in the Company’s internalcontrol over financial reporting occurred during the Company’s last fiscalquarter that has material affected, or is reasonably likely to materially affect,the Company’s internal control over financial reporting.

**Item 9B.**               OtherInformation.

None.

37

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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 2006 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 theRegistrant.

The information required by Item10 of Form 10-K concerning the Registrant’s executive officers isset forth under the heading “Executive Officers” located at the end of Part Iof this Report.

The Board of Directors hasdetermined that the members of the Audit Committee are independent as definedin Rule 4200(a)(15) of the National Association of Securities Dealers’listing standards. The Board of Directors has determined that Martin Maleska isan “audit committee financial expert” as defined in Item 401(h) ofRegulation S-K.

The Board of Directors hasadopted a code of conduct that applies to all of our directors and employees.Our Board has also adopted a separate code of conduct for our Chief ExecutiveOfficer, Chief Financial Officer and Controller, or persons performing similarfunctions. We will provide copies of our codes of conduct without charge uponrequest. To obtain a copy of our codes of conduct, please send your writtenrequest to VCampus Corporation, 1850 Centennial Park Drive, Suite 200,Reston, VA 20191, Attention: Chief Financial Officer.

Theother information required by Item 10 of Form 10-K concerning theRegistrant’s directors is incorporated by reference to the information underthe headings “Proposal No. 1—Election of Directors” and “Other Information—Section 16(a) BeneficialOwnership Reporting Compliance” in the Proxy Statement.

**Item 11.**                 Executive Compensation.

Theinformation required by Item 11 of Form 10-K is incorporated byreference to the information under the heading “Proposal No. 1—Election ofDirectors—Corporate Governance Matters”, “Other Information—ExecutiveCompensation”, “—Compensation of Directors”, “—Employment Agreements”, “—Reportof the Compensation Committee on Executive Compensation”, “—CompensationCommittee Interlocks and Insider Participation” and “—Performance Graph” in theProxy Statement.

**Item 12.**                 Security Ownership of Certain Beneficial Ownersand Management and Related Stockholder Matters.

Theinformation required by Item 12 of Form 10-K is incorporated byreference to the information under the heading “Other Information—PrincipalStockholders” and “Other Information—Equity Compensation Plan Information” inthe Proxy Statement.

**Item 13.**                 Certain Relationships and Related Transactions.

Theinformation required by Item 13 of Form 10-K is incorporated byreference to the information under the heading “Other Information—CertainTransactions” in the Proxy Statement.

**Item 14.**                 PrincipalAccounting Fees and Services

The information requiredby Item 14 of Form 10-K is incorporated by reference to theinformation under the heading “Principal Accounting Fees and Services” in theProxy Statement.

38

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**PART IV**

**Item 15.**                 Exhibits and Financial Statement Schedules.

(a)   The following Financial Statements, Financial Statement Schedulesand Exhibits are filed as part of this report or incorporated herein byreference:

(1)          FinancialStatements.

See Index to Consolidated Financial Statements on page F-1.

(2)          FinancialStatement Schedules.

The following financialstatement schedule is filed with this report: Schedule II—Valuation andQualifying Account and Reserve

All other financial statementschedules for which provision is made in Regulation S-X are omitted becausethey are not required under the related instructions, are inapplicable, or therequired information is given in the financial statements, including the notesthereto and, therefore, have been omitted.

(b)   Exhibits.

| Exhibit No. | ** ** | **Description**                                                                                              |
|------------------|------------|--------------------------------------------------------------------------------------------------------------|
|   3.1(e)    |       | 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.                                                                      |
| 10.9(a)**        |       | 1996  Stock Plan                                                                                             |
| 10.60(b)         |       | Warrant  issued to the purchasers dated as of May 29, 2001.                                             |
| 10.61(b)         |       | Warrant  issued to the placement agent for the May 29, 2001 private placement.                          |
| 10.67(c)         |       | Form of warrant  issued in connection with the Series F, F-1 and F-2  preferred stock financings   |
| 10.68(d)**       |       | Employment  Agreement, dated June 3, 2002, with Christopher L. Nelson                                   |
| 10.79(f)         |       | Form of Warrant  issued on September 30, 2002 to the purchasers of Series G  Preferred Stock. |
|             |       |                                                                                                         |
| 10.84(i)         |       | Form of warrant  issued to the Series H holders on May 13, 2003.                              |
| 10.85(i)         |       | Registration Rights  Agreement dated May 13, 2003 relating to the Series H financing.              |
|             |       |                                                                                                         |
| 10.88(j)**       |       | Amended employment  agreement between VCampus and Christopher L. Nelson dated June 25,  2003.      |
|             |       |                                                                                                         |
| 10.90(j)         |       | Form of warrant  issued in connection with the conversion of VCampus preferred stock.                   |
| 10.91(p)         |       | Purchase Agreement dated  March 23, 2004 for the $5.3 million private placement                         |
| 10.92(p)         |       | Form of  Series A Senior Secured Convertible Note issued on March 23, 2004                    |
| 10.93(p)         |       | Form of  Series B Senior Secured Convertible Note issued on March 23, 2004                    |

39

----

 

| 10.94(p)    |   | Form of Warrant  issued on March 23, 2004 in connection with the $5.3 million private  placement                                               |
|-------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.95(p)    |   | Registration Rights  Agreement dated March 23, 2004 entered into in connection with the $5.3  million private placement                             |
| 10.96(p)    |   | Security Agreement dated  March 23, 2004 entered into in connection with the $5.3 million private  placement                                        |
| 10.97(k)*   |   | Content Client License  Agreement between VCampus and Net Dimensions Limited dated February 24,  2004                                               |
| 10.98(k)    |   | Settlement Agreement and Release between VCampus and  Park University dated May 3, 2004                                                             |
| 10.99(l)    |   | VCampus’ standard form  of Online Content Conversion and Distribution Agreement (also known as the  form of Select Partner Agreement)               |
| 10.100(m)   |   | Form of  Subscription Agreement, dated March 30, 2005, between VCampus and each  of the Purchasers                                             |
| 10.101(m)   |   | Registration Rights  Agreement, dated March 30, 2005, among VCampus and the Purchasers.                                                             |
| 10.102(m)   |   | Form of Warrant  issued by VCampus to each of the Purchasers on March 30, 2005.                                                                |
| 10.103(n)   |   | Form of  Subscription Agreement for December 2005 financing                                                                                    |
| 10.104(n)   |   | Form of Warrant for  December 2005 financing                                                                                                   |
| 10.105(n)   |   | Registration Rights  Agreement for December 2005 financing                                                                                          |
| 10.106(n)   |   | Certificate of  Designations of the Series A-1 Convertible Preferred Stock                                                                          |
| 10.107(o)** |   | Employment Agreement  with Narasimhan P. Kannan dated December 30, 2005.                                                                            |
| 10.108(o)** |   | Amendment No. 3 to  Employment Agreement with Christopher L. Nelson dated January 6, 2006                                                      |
| 10.109      |   | Amendment to Certificate  of Designations of the Series A-1 Convertible Preferred Stock                                                             |
| 10.110      |   | Certificate of  Designations of the Series B-1 Convertible Preferred Stock                                                                          |
| 10.111      |   | Form of  Subscription Agreement for the Series B-1 Preferred Stock  financing                                                                  |
| 10.112      |   | Registration Rights  Agreement for the Series B-1 Preferred Stock financing                                                                         |
| 10.113      |   | Form of Warrant  issued in the Series B-1 Preferred Stock financing                                                                            |
| 10.114*     |   | Agreements representing  the registrant’s renewal of its subcontract to continue performing services  for the Department of Veterans’ Affairs. |
| 21.1        |   | List of Subsidiaries                                                                                                                                     |
| 23.1        |   | Consent of Reznick  Group, P.C., Independent Registered Public Accounting Firm                                                                           |
| 31.1        |   | Certification of Chief  Executive Officer pursuant to Rule 13a-14(a).                                                                               |
| 31.2        |   | Certification of Chief  Financial Officer pursuant to Rule 13a-14(a).                                                                               |
| 32.1        |   | Chief Executive Officer  Certification pursuant to Section 906 of the Sarbanes/Oxley Act of 2002.                                                   |

40

----

 

| 32.2    |   | Chief Financial Officer Certification pursuant to  Section 906 of the Sarbanes/Oxley Act of 2002. |
|---------|--------|--------------------------------------------------------------------------------------------------------|
| 99.4(h) |   | Form of  Warrant issued to the Series F holders on December 28, 2001                    |
| 99.5(h) |   | Form of  Warrant issued to the convertible noteholders on December 28, 2001                  |
| 99.7(b) |   | Audit  Committee Charter                                                                               |

----

*                    Theregistrant has requested and/or received confidential treatment with respect tocertain portions of this exhibit. Such portions have been omitted from thisexhibit and have been filed separately with the SEC.

**             Managementcontract or compensatory plan or arrangement required to be filed as an exhibitto this Annual Report on Form 10-K.

(a)           Incorporatedby reference to the similarly numbered Exhibit to the Registrant’sRegistration Statement on Form S-1 (File No. 333-12135).

(b)          Incorporatedby reference to the similarly numbered Exhibit to the Registrant’s currentreport on Form 8-K filed June 1, 2001.

(c)           Incorporatedby reference to the similarly numbered Exhibit to the Registrant’sQuarterly Report on Form 10-Q filed May 15, 2002.

(d)          Incorporatedby reference to the similarly numbered Exhibit to the Registrant’s currentreport on Form 8-K filed June 28, 2002.

(e)           Incorporatedby reference to the similarly numbered Exhibit to the Registrant’sPost-Effective Amendment No. 1 to Registration Statement No. 333-108380as filed on July 19, 2004.

(f)             Incorporatedby reference to the similarly numbered Exhibit to the Registrant’s currentreport on Form 8-K filed October 3, 2002.

(g)           Notused.

(h)          Incorporatedby reference to the similarly numbered Exhibit to the Registrant’s currentreport on Form 8-K filed January 8, 2002

(i)             Incorporated byreference to the similarly numbered Exhibit to the Registrant’s QuarterlyReport on Form 10-Q filed May 15, 2003.

(j)              Incorporated byreference to the similarly numbered Exhibit to the Registrant’s QuarterlyReport on Form 10-Q for the quarter ended June 30, 2003.

(k)          Incorporated byreference to the similarly numbered Exhibit to the Registrant’s QuarterlyReport on Form 10-Q for the quarter ended March 31, 2004.

(l)             Incorporated byreference to the similarly numbered Exhibit to the Registrant’s QuarterlyReport on Form 10-Q for the quarter ended June 30, 2004.

(m)      Incorporatedby reference to the similarly numbered Exhibit to the Registrant’s currentreport on Form 8-K filed April 4, 2005.

(n)          Incorporatedby reference to the similarly numbered Exhibit to the Registrant’s currentreport on Form 8-K filed December 14, 2005.

(o)  Incorporated byreference to the Exhibits to the Registrant’s current report on Form 8-Kfiled January 6, 2006.

(p)          Incorporated byreference to the similarly numbered Exhibit to the Registrant’s AnnualReport on Form 10-K for the year ended December 31, 2003.

41

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**SIGNATURES**

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities and Exchange Act of 1934, the Registrant has duly caused thisreport to be signed on its behalf by the undersigned, thereunto dulyauthorized.

|        | VCAMPUS CORPORATION |
|--------|---------------------|
|   | By:                 | /s/  NARASIMHAN P. KANNAN |
|   |                | Narasimhan P. Kannan,  Chief Executive Officer |

 

Date: March 21, 2006

Pursuant to the requirements of the Securities ExchangeAct of 1934, this report has been signed below by the following person onbehalf of the Registrant and in the capacities and on the dates indicated.

|                           | **Signature** | ** **                                         | ** ** | ** **           | **Capacity** | ** ** | ** ** | ** ** | **Date** | ** ** |
|---------------------------|---------------|----------------------------------------------------|------------|----------------------|--------------|------------|------------|------------|----------|------------|
| /s/ NARASIMHAN P. KANNAN  |          | Chairman and Chief Executive Officer     |       | March 21, 2006  |
| Narasimhan P. Kannan      |          | (Principal  Executive Officer)                |       |                 |
| /s/ CHRISTOPHER L. NELSON |          | Chief Financial Officer                            |       | March 21, 2006  |
| Christopher  L. Nelson    |          | (Principal  Financial and Accounting Officer) |       |                 |
| /s/ EDSON D. DECASTRO     |          | Director                                           |       | March  21, 2006 |
| Edson  D. deCastro        |          |                                               |       |                 |
| /s/ MARTIN E. MALESKA     |          | Director                                           |       | March 20, 2006  |
| Martin E. Maleska         |          |                                               |       |                 |
| /s/ JOHN D. SEARS         |          | Director                                           |       | March 22, 2006  |
| John D. Sears             |          |                                               |       |                 |

 

 

42

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**VCAMPUS CORPORATION**

**INDEXTO CONSOLIDATED FINANCIAL STATEMENTS**

| Report of Reznick Group,  P.C., Independent Registered Public Accounting Firm                                   |   | F-2  |   |
|-----------------------------------------------------------------------------------------------------------------|--------|------|--------|
| Consolidated  Balance Sheets as of December 31, 2004 and 2005                                              |   | F-3  |   |
| Consolidated Statements of Operations for the years  ended December 31, 2003, 2004 and 2005                |   | F-4  |   |
| Consolidated Statements of Stockholders’ Equity for  the years ended December 31, 2003, 2004 and 2005 |   | F-5  |   |
| Consolidated Statements of Cash Flows for the years  ended December 31, 2003, 2004 and 2005                |   | F-9  |   |
| Notes to Consolidated Financial Statements                                                                      |   | F-10 |   |
| Schedule II—Valuation and Qualifying Account and  Reserve                                                  |   | F-35 |   |

 

F-1

----

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

To Board of Directors and StockholdersVCampus Corporation

We have audited the accompanying consolidated balancesheets of VCampus Corporation and subsidiaries as of December 31, 2004 and2005, and the related consolidated statements of operations, stockholders’equity and cash flows for each of the three years in the period ended December 31,2005. Our audits also included the financial statement schedule listed in theIndex at Item 15(a)2. These financial statements and schedule are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States). TheCompany has determined that it is not required to have, nor were we engaged toperform, an audit of its internal control over financial reporting. Our auditincluded consideration of internal control over financial reporting as a basisfor designing audit procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the consolidated financial statementsare free of material misstatement. An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

In ouropinion, the financial statements referred to above present fairly, in allmaterial respects, the consolidated financial position of VCampus Corporationand subsidiaries at December 31, 2004 and 2005, and the consolidatedresults of their operations and their cash flows for each of the three years inthe period ended December 31, 2005, in conformity with U.S. generallyaccepted accounting principles. Also, in our opinion, the related financialstatement schedule, when considered in relation to the basic financialstatements taken as a whole, present fairly in all material respects theinformation set forth therein.

| /s/ REZNICK GROUP, P.C. |
|-------------------------|

 

Vienna, VirginiaMarch 10, 2006, except for note 15, as to which the date is March 23,2006

F-2

----

**VCAMPUS CORPORATION**

**CONSOLIDATEDBALANCE SHEETS**

| ** **                                                                                                                                                                                                                                     | ** ** | **December 31,  2004** | ** ** | **December 31,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ASSETS                                                                                                                                                                                                                                         |       |                        |       |                        |       |
| Current assets:                                                                                                                                                                                                                                |       |                        |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                                                                      |       | $                           | 2,632,504  |                        | $          | 2,488,159 |   |
| Accounts receivable, less allowance of $5,000 at  December 31, 2004 and 2005                                                                                                                                                              |       | 283,101                     |       | 209,338                     |       |
| Loans receivable from related party                                                                                                                                                                                                            |       | 49,783                      |       | 15,453                      |       |
| Prepaid expenses and other current assets                                                                                                                                                                                                      |       | 665,663                     |       | 325,818                     |       |
| Total current  assets                                                                                                                                                                                                                          |       | 3,631,051                   |       | 3,038,768                   |       |
| Property and  equipment, net                                                                                                                                                                                                                   |       | 523,662                     |       | 313,880                     |       |
| Capitalized  software costs and courseware development costs, net                                                                                                                                                                              |       | 1,826,745                   |       | 1,308,577                   |       |
| Other assets                                                                                                                                                                                                                                   |       | 418,684                     |       | 231,859                     |       |
| Other intangible  assets, net                                                                                                                                                                                                                  |       | 390,502                     |       | 257,006                     |       |
| Goodwill                                                                                                                                                                                                                                       |       | 328,317                     |       | 328,317                     |       |
| Total assets                                                                                                                                                                                                                                   |       | $                           | 7,118,961  |                        | $          | 5,478,407 |   |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                                                                                                     |       |                        |       |                        |       |
| Current liabilities:                                                                                                                                                                                                                           |       |                        |       |                        |       |
| Accounts payable                                                                                                                                                                                                                               |       | $                           | 575,183    |                        | $          | 1,182,585 |   |
| Accrued expenses                                                                                                                                                                                                                               |       | 318,478                     |       | 479,316                     |       |
| Notes payable                                                                                                                                                                                                                                  |       | 66,207                      |       | 191,796                     |       |
| Deferred revenues                                                                                                                                                                                                                              |       | 851,118                     |       | 469,280                     |       |
| Accrued dividends payable on Series A-1  convertible Preferred Stock                                                                                                                                                                      |       | —                      |       | 14,312                      |       |
| Total current liabilities                                                                                                                                                                                                                      |       | 1,810,986                   |       | 2,337,289                   |       |
| Long-term  liabilities:                                                                                                                                                                                                                        |       |                        |       |                        |       |
| Notes payable—less discount and current portion                                                                                                                                                                                           |       | 463,446                     |       | 479,489                     |       |
| Total liabilities                                                                                                                                                                                                                              |       | 2,274,432                   |       | 2,816,778                   |       |
| Commitments and  contingencies:                                                                                                                                                                                                                |       | —                      |       | —                      |       |
| Stockholders’  equity:                                                                                                                                                                                                                    |       |                        |       |                        |       |
| Series A-1 convertible Preferred Stock,  $0.01 par value per share; aggregate liquidation preference of $2,356,312;  5,000 shares authorized; 0 and 2,342 shares issued and outstanding at  December 31, 2004 and 2005, respectively |       | —                      |       | 23                          |       |
| Common Stock, $0.01 par value per share; 36,000,000  shares authorized; 8,461,086 and 9,592,074 shares issued and outstanding at  December 31, 2004 and 2005, respectively                                                                |       | 84,611                      |       | 95,921                      |       |
| Additional paid-in capital                                                                                                                                                                                                                     |       | 101,732,238                 |       | 105,418,644                 |       |
| Accumulated deficit                                                                                                                                                                                                                            |       | (96,972,320                 | )          | (102,852,959                | )          |
| Total stockholders’ equity                                                                                                                                                                                                                |       | 4,844,529                   |       | 2,661,629                   |       |
| Total liabilities  and stockholders’ equity                                                                                                                                                                                               |       | $                           | 7,118,961  |                        | $          | 5,478,407 |   |

 

The accompanyingnotes are an integral part of the consolidated financial statements.

F-3

----

**VCAMPUS CORPORATION**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

| ** **                                     | ** ** | **Years ended December 31,** | ** ** |
|------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                     | ** ** | **2003**                                    | ** ** | **2004** | ** ** | **2005** | ** ** |
| Revenues:                                      |       |                                        |       |   |   |   |   |
| Online tuition revenues                        |       | $                                           | 5,508,154  |   | $ | 4,497,513 |   | $ | 4,045,979 |   |
| Online development and other revenues          |       | 448,082                                     |       | 318,456 |   | 518,484 |   |
| Other service revenues                         |       | 109,799                                     |       | 47,890 |   | — |   |
| Net revenues                                   |       | 6,066,035                                   |       | 4,863,859 |   | 4,564,463 |   |
| Costs and expenses:                            |       |                                        |       |   |   |   |   |
| Cost of revenues                               |       | 1,718,340                                   |       | 1,356,699 |   | 1,730,892 |   |
| Sales and marketing                            |       | 2,137,791                                   |       | 1,895,340 |   | 1,723,313 |   |
| Product development and operations             |       | 2,474,856                                   |       | 2,725,155 |   | 2,649,215 |   |
| General and administrative                     |       | 1,909,814                                   |       | 1,686,940 |   | 1,488,240 |   |
| Depreciation and amortization                  |       | 879,966                                     |       | 1,227,089 |   | 1,574,242 |   |
| Reorganization and other non-recurring charges |       | 172,729                                     |       | — |   | — |   |
| Stock-based compensation                       |       | 126,056                                     |       | 153,973 |   | 109,493 |   |
| Total costs and  expenses                      |       | 9,419,552                                   |       | 9,045,196 |   | 9,275,395 |   |
| Loss from  operations                          |       | (3,353,517                                  | )          | (4,181,337 | ) | (4,710,932 | ) |
| Other income                                   |       | 207,138                                     |       | 183,210 |   | — |   |
| Interest expense,  net                         |       | (112,644                                    | )          | (2,581,289 | ) | (1,155,395 | ) |
| Net loss                                       |       | (3,259,023                                  | )          | (6,579,416 | ) | (5,866,327 | ) |
| Dividends to  preferred stockholders           |       | (2,926,854                                  | )          | — |   | (14,312 | ) |
| Net loss  attributable to common stockholders  |       | $                                           | (6,185,877 | ) | $ | (6,579,416 | ) | $ | (5,880,639 | ) |
| Basic and diluted net  loss per share          |       | $                                           | (1.81      | ) | $ | (0.97 | ) | $ | (0.63 | ) |

 

The accompanyingnotes are an integral part of the consolidated financial statements.

F-4

----

**VCAMPUS CORPORATIONCONSOLIDATED STATEMENTSOF 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, 2002                                   |       | 623,339                                              |       | $                                                    | 6,233      |                                                 | 1,013,809  |   | $ | 10,138 |   | 574,895 |   | $ | 5,749 |   |
| Issuance of Preferred Stock for payment of  Series E Dividends |       | —                                               |       | —                                               |       | —                                               |       | — |   | 9,940 |   | 100 |   |
| Issuance of Series G convertible Preferred Stock               |       | —                                               |       | —                                               |       | —                                               |       | — |   | — |   | — |   |
| Issuance of Series H convertible Preferred Stock               |       | —                                               |       | —                                               |       | —                                               |       | — |   | — |   | — |   |
| Issuance of Common Stock                                            |       | —                                               |       | —                                               |       | —                                               |       | — |   | — |   | — |   |
| Conversion of Preferred Stock to common stock                       |       | (623,339                                             | )          | (6,233                                               | )          | (1,013,809                                           | )          | (10,138 | ) | (584,835 | ) | (5,849 | ) |
| Compensatory stock, stock options and warrants                      |       | —                                               |       | —                                               |       | —                                               |       | — |   | — |   | — |   |
| Net loss                                                            |       | —                                               |       | —                                               |       | —                                               |       | — |   | — |   | — |   |
| Balance at December 31, 2003                                   |       | —                                               |       | $                                                    | —     |                                                 | —     |   | $ | — |   | — |   | $ | — |   |
| Issuance of Common Stock                                            |       | —                                               |       | —                                               |       | —                                               |       | — |   | — |   | — |   |
| Issuance of Common Stock in connection with  debt conversions       |       | —                                               |       | —                                               |       | —                                               |       | — |   | — |   | — |   |
| Exercises of options and  warrants                                  |       |                                                 |       |                                                 |       |                                                 |       |   |   |   |   |   |   |
| Compensatory stock, stock options and warrants                      |       | —                                               |       | —                                               |       | —                                               |       | — |   | — |   | — |   |
| Net loss                                                            |       | —                                               |       | —                                               |       | —                                               |       | — |   | — |   | — |   |
| Balance at December 31, 2004                                   |       | —                                               |       | $                                                    | —     |                                                 | —     |   | $ | — |   | — |   | $ | — |   |
| Issuance of Series A-1 convertible  Preferred Stock            |       | —                                               |       | —                                               |       | —                                               |       | — |   | — |   | — |   |
| Issuance of Common Stock                                            |       | —                                               |       | —                                               |       | —                                               |       | — |   | — |   | — |   |
| Issuance of Common Stock in connection with  debt conversions       |       | —                                               |       | —                                               |       | —                                               |       | — |   | — |   | — |   |
| Exercises of options and  warrants                                  |       |                                                 |       |                                                 |       |                                                 |       |   |   |   |   |   |   |
| Compensatory stock, stock options and warrants                      |       | —                                               |       | —                                               |       | —                                               |       | — |   | — |   | — |   |
| Net loss                                                            |       | —                                               |       | —                                               |       | —                                               |       | — |   | — |   | — |   |
| Dividends on convertible Preferred Stock                            |       | —                                               |       | —                                               |       | —                                               |       | — |   | — |   | — |   |
| Balance at  December 31, 2005                                  |       | —                                               |       | $                                                    | —     |                                                 | —     |   | $ | — |   | — |   | $ | — |   |

 

F-5

----

**VCAMPUS CORPORATIONCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (Continued)**

| ** **                                                          | ** ** | **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, 2002                                   |       | 3,000,000                                            |       | $                                                      | 30,000     |                                                   | 1,458,413  |   | $ | 14,584 |   | 27,578 |   |   | $ | 276 |   |   |
| Issuance of Preferred Stock for payment of Series E  Dividends |       | —                                               |       | —                                                 |       | —                                                 |       | — |   | — |   |   | — |   |   |
| Issuance of Series G convertible Preferred Stock               |       | —                                               |       | —                                                 |       | —                                                 |       | — |   | — |   |   | — |   |   |
| Issuance of Series H convertible Preferred Stock               |       | —                                               |       | —                                                 |       | —                                                 |       | — |   | — |   |   | — |   |   |
| Issuance of Common Stock                                            |       | —                                               |       | —                                                 |       | —                                                 |       | — |   | — |   |   | — |   |   |
| Conversion of Preferred Stock to common stock                       |       | (3,000,000                                           | )          | (30,000                                                | )          | (1,458,413                                             | )          | (14,584 | ) | (27,578 | ) |   | (276 | ) |   |
| Compensatory stock, stock options and warrants                      |       | —                                               |       | —                                                 |       | —                                                 |       | — |   | — |   |   | — |   |   |
| Net loss                                                            |       | —                                               |       | —                                                 |       | —                                                 |       | — |   | — |   |   | — |   |   |
| Balance at December 31, 2003                                   |       | —                                               |       | $                                                      | —     |                                                   | —     |   | $ | — |   | — |   |   | $ | — |   |   |
| Issuance of Common Stock                                            |       | —                                               |       | —                                                 |       | —                                                 |       | — |   | — |   |   | — |   |   |
| Issuance of Common Stock in connection with  debt conversions       |       | —                                               |       | —                                                 |       | —                                                 |       | — |   | — |   |   | — |   |   |
| Exercises of options and warrants                                   |       | —                                               |       | —                                                 |       | —                                                 |       | — |   | — |   |   | — |   |   |
| Compensatory stock, stock options and warrants                      |       | —                                               |       | —                                                 |       | —                                                 |       | — |   | — |   |   | — |   |   |
| Net loss                                                            |       | —                                               |       | —                                                 |       | —                                                 |       | — |   | — |   |   | — |   |   |
| Balance at December 31, 2004                                   |       | —                                               |       | $                                                      | —     |                                                   | —     |   | $ | — |   | — |   |   | $ | — |   |   |
| Issuance of Series A-1 convertible  Preferred Stock       |       | —                                               |       | —                                                 |       | —                                                 |       | — |   | — |   |   | — |   |   |
| Issuance of Common Stock                                            |       | —                                               |       | —                                                 |       | —                                                 |       | — |   | — |   |   | — |   |   |
| Issuance of Common Stock in connection with  debt conversions       |       | —                                               |       | —                                                 |       | —                                                 |       | — |   | — |   |   | — |   |   |
| Exercises of options and warrants                                   |       | —                                               |       | —                                                 |       | —                                                 |       | — |   | — |   |   | — |   |   |
| Compensatory stock, stock options and warrants                      |       | —                                               |       | —                                                 |       | —                                                 |       | — |   | — |   |   | — |   |   |
| Net loss                                                            |       | —                                               |       | —                                                 |       | —                                                 |       | — |   | — |   |   | — |   |   |
| Dividends on convertible Preferred Stock                            |       | —                                               |       | —                                                 |       | —                                                 |       | — |   | — |   |   | — |   |   |
| Balance at  December 31, 2005                                  |       | —                                               |       | $                                                      | —     |                                                   | —     |   | $ | — |   | — |   |   | $ | — |   |   |

 

F-6

----

**VCAMPUS CORPORATIONCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (Continued)**

| ** **                                                          | ** ** | **Series G  Convertible** | ** ** | **Series H  Convertible** | ** ** | **Series A-1  Convertible** | ** ** | ** **            | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|----------------------------------|------------|-----------------------|------------|------------|------------|
| ** **                                                          | ** ** | **Preferred Stock**       | ** ** | **Preferred Stock**       | ** ** | **Preferred Stock**         | ** ** | **Common Stock** | ** ** |
| ** **                                                          | ** ** | **Shares**                     | ** ** | **Amount**                     | ** ** | **Shares**                       | ** ** | **Amount**            | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Shares** | ** ** | **Amount** | ** ** |
| Balance at December 31, 2002                                   |       | 49,320                         |       |                           | $          | 492                              |       |                  |       | —     |       |   |   | $ | — |   |   |   | — |   |   |   | $ | — |   |   | 1,573,904 |   | $ | 15,739 |   |
| Issuance of Preferred Stock for  payment of Series E Dividends |       | —                         |       |                           | —     |                             |       |                  | —     |       |       |   | — |   |   |   | — |   |   |   | — |   |   | — |   | — |   |
| Issuance of Series G convertible Preferred Stock               |       | 28,721                         |       |                           | 288        |                             |       |                  | —     |       |       |   | — |   |   |   | — |   |   |   | — |   |   | — |   | — |   |
| Issuance of Series H convertible Preferred Stock               |       | —                         |       |                           | —     |                             |       |                  | 7,503      |       |       |   | 75 |   |   |   | — |   |   |   | — |   |   | — |   | — |   |
| Issuance of Common Stock                                            |       | —                         |       |                           | —     |                             |       |                  | —     |       |       |   | — |   |   |   | — |   |   |   | — |   |   | 548,551 |   | 5,486 |   |
| Conversion of Preferred Stock to common stock                       |       | (78,041                        |       |                           | (780       | )                                |       |                  | (7,503     | )          |       |   | (75 | ) |   |   | — |   |   |   | — |   |   | 3,008,886 |   | 30,088 |   |
| Compensatory stock, stock options  and warrants                     |       | —                         |       |                           | —     |                             |       |                  | —     |       |       |   | — |   |   |   | — |   |   |   | — |   |   | 35,659 |   | 357 |   |
| Net loss                                                            |       | —                         |       |                           | —     |                             |       |                  | —     |       |       |   | — |   |   |   | — |   |   |   | — |   |   | — |   | — |   |
| Balance at December 31, 2003                                   |       | —                         |       |                           | $          | —                           |       |                  |       | —     |       |   |   | $ | — |   |   |   | — |   |   |   | $ | — |   |   | 5,167,000 |   | $ | 51,670 |   |
| Issuance of Common Stock                                            |       | —                         |       |                           | —     |                             |       |                  | —     |       |       |   | — |   |   |   | — |   |   |   | — |   |   | 1,012,500 |   | 10,125 |   |
| Issuance of Common Stock in connection with debt  conversions       |       | —                         |       |                           | —     |                             |       |                  | —     |       |       |   | — |   |   |   | — |   |   |   | — |   |   | 1,076,772 |   | 10,766 |   |
| Exercises of options and warrants                                   |       | —                         |       |                           | —     |                             |       |                  | —     |       |       |   | — |   |   |   | — |   |   |   | — |   |   | 1,132,617 |   | 11,326 |   |
| Compensatory stock, stock options  and warrants                     |       | —                         |       |                           | —     |                             |       |                  | —     |       |       |   | — |   |   |   | — |   |   |   | — |   |   | 72,197 |   | 724 |   |
| Net loss                                                            |       | —                         |       |                           | —     |                             |       |                  | —     |       |       |   | — |   |   |   | — |   |   |   | — |   |   | — |   | — |   |
| Balance at December 31, 2004                                   |       | —                         |       |                           | $          | —                           |       |                  |       | —     |       |   |   | $ | — |   |   |   | — |   |   |   | $ | — |   |   | 8,461,086 |   | $ | 84,611 |   |
| Issuance of Series A-1 convertible  Preferred Stock            |       | —                         |       |                           | —     |                             |       |                  | —     |       |       |   | — |   |   |   | 2,342 |   |   |   | 23 |   |   | — |   | — |   |
| Issuance of Common Stock                                            |       | —                         |       |                           | —     |                             |       |                  | —     |       |       |   | — |   |   |   | — |   |   |   | — |   |   | 611,012 |   | 6,110 |   |
| Issuance of Common Stock in connection with debt  conversions       |       | —                         |       |                           | —     |                             |       |                  | —     |       |       |   | — |   |   |   | — |   |   |   | — |   |   | 386,152 |   | 3,862 |   |
| Exercises of options and warrants                                   |       | —                         |       |                           | —     |                             |       |                  | —     |       |       |   | — |   |   |   | — |   |   |   | — |   |   | — |   | — |   |
| Compensatory stock, stock options  and warrants                     |       | —                         |       |                           | —     |                             |       |                  | —     |       |       |   | — |   |   |   | — |   |   |   | — |   |   | 133,824 |   | 1,338 |   |
| Net loss                                                            |       | —                         |       |                           | —     |                             |       |                  | —     |       |       |   | — |   |   |   | — |   |   |   | — |   |   | — |   | — |   |
| Dividends on convertible Preferred Stock                            |       | —                         |       |                           | —     |                             |       |                  | —     |       |       |   | — |   |   |   | — |   |   |   | — |   |   | — |   | — |   |
| Balance at  December 31, 2005                                  |       | —                         |       |                           | $          | —                           |       |                  |       | —     |       |   |   | $ | — |   |   |   | 2,342 |   |   |   | $ | 23 |   |   | 9,592,074 |   | $ | 95,921 |   |

 

F-7

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**VCAMPUS CORPORATIONCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (Continued)**

| ** **                                                          | ** ** | **Additional  Paid in  Capital** | ** **  | **Accumulated   Deficit** | ** ** | **Total   Stockholders’   Equity** | ** ** |
|---------------------------------------------------------------------|------------|---------------------------------------|-------------|--------------------------------|------------|---------------------------------------------------|------------|
| Balance at December 31, 2002                                   |       | $                                     | 85,771,622  |                           | $          | (84,207,028                                       | )          |   | $ | 1,647,805 |   |   |
| Issuance of Preferred Stock for payment of  Series E Dividends |       | 3,248                                 |        | (3,348                         | )          |                                              | —     |   |   |
| Issuance of Series G convertible Preferred Stock               |       | 874,649                               |        | —                         |       |                                              | 874,937    |   |   |
| Issuance of Series H convertible Preferred Stock               |       | 1,740,165                             |        | —                         |       |                                              | 1,740,240  |   |   |
| Issuance of Common Stock                                            |       | 899,844                               |        | —                         |       |                                              | 905,330    |   |   |
| Conversion of Preferred Stock to common stock                       |       | 37,847                                |        | —                         |       |                                              | —     |   |   |
| Compensatory stock, stock options and warrants                      |       | 3,049,204                             |        | (2,923,505                     | )          |                                              | 126,056    |   |   |
| Net loss                                                            |       | —                                |        | (3,259,023                     | )          |                                              | (3,259,023 | ) |   |
| Balance at December 31, 2003                                   |       | $                                     | 92,376,579  |                           | $          | (90,392,904                                       | )          |   | $ | 2,035,345 |   |   |
| Issuance of Common Stock                                            |       | 1,520,209                             |        | —                         |       |                                              | 1,530,334  |   |   |
| Issuance of Common Stock in connection with debt  conversions       |       | 1,808,808                             |        | —                         |       |                                              | 1,819,574  |   |   |
| Exercises of options and warrants                                   |       | 1,932,957                             |        | —                         |       |                                              | 1,944,283  |   |   |
| Compensatory stock, stock options and warrants                      |       | 4,093,685                             |        | —                         |       |                                              | 4,094,409  |   |   |
| Net loss                                                            |       | —                                |        | (6,579,416                     | )          |                                              | (6,579,416 | ) |   |
| Balance at December 31, 2004                                   |       | $                                     | 101,732,238 |                           | $          | (96,972,320                                       | )          |   | $ | 4,844,529 |   |   |
| Issuance of Series A-1 convertible  Preferred Stock            |       | 2,032,833                             |        | —                         |       |                                              | 2,032,856  |   |   |
| Issuance of Common Stock                                            |       | 894,340                               |        | —                         |       |                                              | 900,450    |   |   |
| Issuance of Common Stock in connection with debt  conversions       |       | 625,579                               |        | —                         |       |                                              | 629,441    |   |   |
| Exercises of options and warrants                                   |       | —                                |        | —                         |       |                                              | —     |   |   |
| Compensatory stock, stock options and warrants                      |       | 133,654                               |        | —                         |       |                                              | 134,992    |   |   |
| Net loss                                                            |       | —                                |        | (5,866,327                     | )          |                                              | (5,866,327 | ) |   |
| Dividends on convertible Preferred Stock                            |       | —                                |        | (14,312                        | )          |                                              | (14,312    | ) |   |
| Balance at  December 31, 2005                                  |       | $                                     | 105,418,644 |                           | $          | (102,852,959                                      | )          |   | $ | 2,661,629 |   |   |

 

The accompanyingnotes are an integral part of the consolidated financial statements.

F-8

----

**VCAMPUS CORPORATIONCONSOLIDATED STATEMENTSOF CASH FLOWS**

| ** **                                                                                              | ** ** | **Years ended December 31,** | ** **   |
|---------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|--------------|
| ** **                                                                                              | ** ** | **2003**                                    | ** **   | **2004** | ** ** | **2005** | ** ** |
| **Operating Activities**                                                                                |       |                                        |         |   |   |   |   |
| Net loss                                                                                                |       | $                                           | (3,259,023   | ) | $ | (6,579,416 | ) | $ | (5,866,327 | ) |
| Adjustments to reconcile  net loss to net cash used in operating activities:                            |       |                                        |         |   |   |   |   |
| Depreciation                                                                                            |       | 283,354                                     |         | 290,050 |   | 300,067 |   |
| Amortization                                                                                            |       | 596,611                                     |         | 937,039 |   | 1,025,199 |   |
| Bad debt expense                                                                                        |       | 8,622                                       |         | — |   | — |   |
| Impairment of capitalized software and courseware  development costs                                    |       | —                                      |         | — |   | 248,976 |   |
| Non-cash stock option and stock warrant expense                                                         |       | 126,056                                     |         | 153,973 |   | 109,493 |   |
| Debt discount and deferred financing costs  amortization                                                |       | 84,841                                      |         | 2,430,849 |   | 1,060,057 |   |
| Interest expense paid with stock                                                                        |       | —                                      |         | 117,992 |   | 42,400 |   |
| Settlement of accounts payable and accrued expenses                                                     |       | —                                      |         | (183,210 | ) | — |   |
| Decrease in allowance for doubtful accounts                                                             |       | (26,019                                     | )            | — |   | (584 | ) |
| Changes  in operating assets and liabilities:                                                           |       |                                        |         |   |   |   |   |
| Accounts receivable                                                                                     |       | 81,207                                      |         | 7,429 |   | 74,346 |   |
| Prepaid expenses and other current assets                                                               |       | (32,194                                     | )            | 116,053 |   | 315,812 |   |
| Other assets                                                                                            |       | 62,848                                      |         | 1,118 |   | 44,541 |   |
| Accounts payable and accrued expenses                                                                   |       | (185,971                                    | )            | (541,359 | ) | 838,972 |   |
| Deferred revenues                                                                                       |       | 227,560                                     |         | (159,445 | ) | (381,838 | ) |
| Net cash used in operating activities                                                                   |       | (2,032,108                                  | )            | (3,408,927 | ) | (2,188,886 | ) |
| **Investing  Activities**                                                                               |       |                                        |         |   |   |   |   |
| Purchases of property and equipment                                                                     |       | (464,720                                    | )            | (305,374 | ) | (90,284 | ) |
| Proceeds from the sale of property and equipment                                                        |       | —                                      |         | 1,324 |   | — |   |
| Capitalized software and courseware development costs                                                   |       | (1,255,579                                  | )            | (931,497 | ) | (622,510 | ) |
| Proceeds from loans receivable from related party                                                       |       | 36,000                                      |         | 36,000 |   | 36,000 |   |
| Interest on loans receivable from related party                                                         |       | (2,992                                      | )            | (2,038 | ) | (1,670 | ) |
| Proceeds from loans receivable                                                                          |       | 35,000                                      |         | 74,252 |   | — |   |
| Advances under loans receivable                                                                         |       | (5,061                                      | )            | — |   | — |   |
| Net cash used in investing activities                                                                   |       | (1,657,352                                  | )            | (1,127,333 | ) | (678,464 | ) |
| **Financing  Activities**                                                                               |       |                                        |         |   |   |   |   |
| Proceeds from issuance of Common Stock                                                                  |       | 905,330                                     |         | 3,474,614 |   | 900,450 |   |
| Proceeds from the issuance of Series G  convertible Preferred Stock,  net of offering costs   |       | 874,937                                     |         | — |   | — |   |
| Proceeds from the issuance of Series H  convertible Preferred Stock,  net of offering costs   |       | 1,740,240                                   |         | — |   | — |   |
| Proceeds from the issuance of Series A-1  convertible Preferred Stock,  net of offering costs |       | —                                      |         | — |   | 2,032,856 |   |
| Payments on capital lease obligations                                                                   |       | (23,529                                     | )            | — |   | — |   |
| Proceeds from notes payable                                                                             |       | —                                      |         | 3,384,166 |   | — |   |
| Repayments of notes payable                                                                             |       | —                                      |         | (225,000 | ) | (210,301 | ) |
| Net cash provided by financing activities                                                               |       | 3,496,978                                   |         | 6,633,780 |   | 2,723,005 |   |
| Net increase (decrease) in cash and cash equivalents                                                    |       | (192,482                                    | )            | 2,097,520 |   | (144,345 | ) |
| Cash and cash equivalents at the beginning of the  year                                                 |       | 727,466                                     |         | 534,984 |   | 2,632,504 |   |
| Cash and cash equivalents at the end of the year                                                        |       | $                                           | 534,984      |   | $ | 2,632,504 |   | $ | 2,488,159 |   |
| **Supplemental cash flow information:**                                                                 |       |                                        |         |   |   |   |   |
| Interest paid                                                                                           |       | $                                           | —— |   | $ | 43,530 |   | $ | 66,703 |   |

 

The accompanyingnotes are an integral part of the consolidated financial statements.

F-9

----

**VCAMPUS CORPORATION**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

**1.**   Organization andNature of Operations

VCampus Corporation (the “Company”) was incorporatedin Virginia in 1984 and reincorporated in Delaware in 1985. VCampus Corporationis a provider of outsourced e-Learning services. The Company developscourseware and manages and hosts Internet-based learning environments forprofessional credentialing and certification organizations, corporations,government agencies, and associations. The Company’s services cover a broadrange of e-Learning programs, from registration,  enrollment and course delivery  to custom course development, e-commerce andpublishing, as well as tracking of students’ progress, reporting of results andproduction of certificates of completion.

*Management’s Plans toAddress Operating Conditions*

TheCompany has incurred significant losses since inception. The Company expectsnegative cash flow from operations to continue until the Select Partnerbusiness model matures. In addition, the Company has experienced decliningrevenues in the current and prior periods, including the loss of a majorcustomer in 2004 which represented 25% of revenues in 2004.

Management’splans to address these conditions include sales to new customers through theSelect Partner program which have partially replaced the sales related tothe customer lost in 2004. Management anticipates the increasein sales seen in the current and prior periods under the Select Partnerprogram to continue in 2006. Management has also instituted cost cuttingmeasures and operates under an  approvedbudget which is closely monitored. Management is committed to maintainingoperations at current levels to meet projected sales levels.

If the Company is not able to address its funding needs,it will be materially adversely affected. The Company’s future capitalrequirements will depend on many factors, including, but not limited to,acceptance of and demand for its products and services including the SelectPartner business model, use of cash to finance any acquisitions it mightpursue, customer demands for technology upgrades, the types of arrangementsthat the Company may enter into with customers and agents, and the extent towhich the Company invests in new technology and research and developmentprojects. While the Company believes it has the ability to raise additionalcapital, the Company’s ability to raise capital beyond the $1,000,000 and $2,300,000 raised in the March and December 2005private placements (see note 11) is uncertain. If the Company is unable toraise additional funding to meet working capital requirements and comply withthe minimum bid price requirement, it may be unable to maintain compliance withNasdaq Capital market listing requirements.

**2.**   Summary ofSignificant Accounting Policies

*Principles ofConsolidation*

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

*Use of Estimates*

The preparation of the consolidated financialstatements in conformity with U.S. generally accepted accounting principlesrequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the consolidated financial statements and thereported amounts of revenues and expenses during the reporting period. Actualresults could differ from those estimates.

F-10

----

*Cash Equivalents*

Cash equivalents, consist of highly liquidinvestments, which are readily convertible into cash and have originalmaturities of three months or less.

*Non-Cash FinancingActivities*

In February 2003,the Company issued 226 shares of Series G Preferred Stock with anaggregate value of $8,927 and five-year fully vested warrants to purchase 564shares of common stock with an exercise price of $2.99 per share to a placementagent in connection with private placement of its Series G Preferred Stock.As this was a placement of preferred stock, the fair value of the common stockand warrants issued to the placement agent was accounted for as cost ofcapital.

In September and October 2003, theCompany issued an aggregate of 27,711 shares of its common stock with anaggregate value of $71,771 and three-year fully vested warrants to purchase27,711 shares of common stock with an exercise price of $2.59 per share to aplacement agent in connection with the financings completed in that period. Asthis was a placement of common stock, the fair value of the common stock andwarrants issued to the placement agent was accounted for as cost of capital.

In2004, the Company issued 927,696 shares of common stock upon mandatory andvoluntary conversions of $999,625 and $512,500, respectively, of Series Aand Series B senior secured convertible note principal at $1.63 per share.

In March andMay 2004, the Company issued 76,688 shares of common stock with a value of$189,419 and five-year fully vested warrants to purchase 250,000 shares of commonstock at $1.63 per share valued at $545,000 in satisfaction of accruedfinancing costs related to the March 2004 private placement. The Companyallocated $505,730 of the total value of the shares and warrants to deferreddebt issuance costs, which will be recognized as interest expense over theperiod the notes are expected to be outstanding. The remaining amount wasaccounted for as a cost of capital. In addition, the Company issued one quarterunit of the March 2004 private placement with an aggregate value of$50,000 to the lead investor’s counsel as payment for legal services inconnection with the private placement. The Company allocated $34,430 of thetotal value of the one quarter unit to deferred debt issuance costs, which willbe recognized as interest expense over the period the notes are expected to beoutstanding. The remaining amount was accounted for as a cost of capital.

In2005, the Company issued 332,398 shares of common stock upon voluntaryconversions of $541,809 of Series A and Series B senior securedconvertible note principal at $1.63 per share.

In2005, the Company issued 30,550 shares of common stock with a value of $50,000in satisfaction of a finder’s fee related to the March 2005 privateplacement. In 2005, the Company issued 42 shares of Series A-1Preferred Stock and a five-year warrant to purchase 75,450 shares of commonstock, in satisfaction of a finder’s fee related to the December 2005private placement. The Series A-1 Preferred Stock and warrant havethe same terms as the securities issued in the December 2005 financing.

In2005, the Company issued 11,860 shares of common stock with a value of $25,500in satisfaction of accounts payable to a financial advisor.

In2005, the Company issued 27,749 shares of common stock with a value of $45,232in satisfaction of accrued and unpaid interest on its Series A and Series Bsecured convertible notes.

In 2005, the Company declared and accrued $14,312 ofdividends on its Series A-1 convertible Preferred Stock.

*Accounts Receivable*

Accounts receivable are recorded at the invoicedamount and do not bear interest. The allowance for doubtful accounts is theCompany’s best estimate of the amount of probable credit losses in the Company’s

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existing accountsreceivable. The Company determines the allowance based on historical write-offexperience. The Company reviews its allowance for doubtful accounts monthly.Past due balances over 90 days are reviewed individually for collectibility.Account balances are charged off against the allowance after all means ofcollection have been exhausted and the potential for recovery is consideredremote. The Company does not have any off-balance sheet credit exposure relatedto its customers.

*Loans Receivable*

The Company periodically assesses the collectibilityof its loans receivable and records balances due at the amount it believes itwill be able to collect during the term of the loan.

*Property and Equipment*

Property and equipment are stated at cost lessaccumulated depreciation. Depreciation is computed using the straight-linemethod over the estimated useful lives of two to seven years. Leaseholdimprovements are amortized over the lesser of the lease term or estimateduseful life. Repairs and maintenance that do not improve or extend the lives ofthe respective assets are expensed in the period incurred. Depreciation expensewas $283,354, $290,050 and $300,067 for 2003, 2004 and 2005, respectively.

*Capitalized Software andCourseware Development Costs*

During 2003, 2004 and 2005, theCompany capitalized certain software and courseware development costs. TheCompany capitalizes the cost of software used for internal operationsonce technological feasibility of the software has been demonstrated. The Company capitalizes costs incurred during thedevelopment process, including payroll costs for employees who are directlyassociated with the development process and services performed by consultants.Amortization of such costs is based on the greater of (1) the ratio ofcurrent gross revenues to the sum of current and anticipated gross revenues, or(2) the straight-line method over the remaining economic life of thevcampus or courseware, typically two to three years. It is possible that thoseanticipated gross revenues, the remaining economic life of the products, orboth, may be reduced as a result of future events. During 2003, 2004 and 2005,the Company recognized amortization of capitalized software and coursewaredevelopment costs of $417,613, $758,047, and $891,702, respectively. During the2005, the Company wrote off $248,976 in unamortized capitalized software andcourseware development costs for a total of nine courses, as a result ofimpairment analyses conducted by the Company in connection with the review ofits financial statements. The Company determined that the impairment chargeswere necessary because the carrying amount of the assets represented by thecourses exceeded the Company’s determination of the fair value of the assets. Thewrite-offs have been included in depreciation and amortization expense in the2005 statements of operations.

*Web Site Development 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*(“EITF 00-2”). In 2003, 2004 and 2005 all web site development costs wereincurred in the operating stage, including maintenance and minor enhancementsand upgrades, and were expensed as incurred.

*Goodwill and OtherIntangible Assets*

Goodwilland other intangibles represent the unamortized excess of the cost of acquiringsubsidiary companies over the fair values of such companies’ net tangibleassets at the dates of acquisition.

On January 1,2002, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 142,“Goodwill and Other Intangible Assets” (SFAS 142).  The Company does not have any indefinite-livedintangibles. In accordance with SFAS 142, the Company reviewed the usefullives of its intangible assets and determined that they remained appropriate.

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Inconnection with the adoption of SFAS 142, the Company performed anassessment of whether there were indicators that goodwill was impaired at thedate of adoption. To accomplish this, the Company identified its reportingunits and determined the carrying value of each reporting unit. The Companythen determined the fair value of the reporting unit and compared it to thereporting unit’s carrying amount. To the extent the reporting unit’s carryingamount exceeds its fair value, an indication exists that the reporting unit’sgoodwill may be impaired and the Company must perform the second step of theimpairment test. In the second step, the Company must compare the implied fairvalue of the reporting unit’s goodwill, determined by allocating the reportingunit’s fair value to all of its assets and liabilities in a manner similar to apurchase price allocation in accordance with SFAS 141, to its carryingamount, 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. TheCompany considers itself to be a single reporting unit. Accordingly, all of theCompany’s goodwill is associated with the entire Company. The Company performedits initial impairment test and as of June 30, 2002, based on the Company’smarket capitalization; there was no impairment of goodwill recorded uponimplementation of SFAS 142. The Company has tested and will continue totest for impairment on an annual basis, coinciding with its fiscal year end, oron an interim basis if circumstances change that would more likely than notreduce the fair value of the Company’s reporting unit below its carryingamount. The Company performed its annual impairment test as of December 31,2005, and concluded that no impairment charge for goodwill and other intangibleassets was required.

*Impairment of Long-LivedAssets*

TheCompany accounts for long-lived assets in accordance with the provisions ofSFAS No. 144, *Accounting for theImpairment or Disposal of Long-Lived Assets* (SFAS No. 144). SFASNo. 144 requires that long-lived assets and certain identifiableintangibles be reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not be recoverable.

Recoverabilityof assets is measured by comparing the carrying amount of an asset to futureundiscounted net cash flows expected to be generated by the asset. If suchassets are considered to be impaired, the impairment to be recognized is measuredby the amount by which the carrying amount of the assets exceeds the fair valueof the assets. Assets to be disposed of by sale are reflected at the lower oftheir carrying amount or fair value less cost to sell.

During 2005, the Company wrote off $248,976 inunamortized capitalized software and courseware development costs for a totalof nine courses, as a result of impairment analyses conducted by the Company inconnection with the review of its financial statements. The Company determinedthat the impairment charges were necessary because the carrying amount of theassets represented by the courses exceeded the Company’s determination of thefair value of the assets. The write-offs have been included in depreciation andamortization expense in the 2005 statements of operations.

*Revenue Recognition*

TheCompany currently derives its revenues from online tuition revenues anddevelopment and other revenues.

Onlinetuition revenues are generated primarily through three types of contracts: (i) corporatesubscriptions, (ii) contracts with Select Partners and (iii) corporateusage. Under corporate subscriptions and Select Partner contracts, revenue isrecognized ratably (on a straight-line basis) over the subscription period. Forusage contracts, revenue is recognized upon enrollment in a course. Once astudent has enrolled in a course, he cannot cancel delivery of a course orreceive a refund. On rare occasions, the Company may extend the subscriptionlength for a specific student’s course at no charge. Initial set-up feesrelated to all online tuition services are recognized ratably (on astraight-line basis) over the respective contract term.

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Development and other revenues consist primarily offees paid to the Company for developing and converting courseware. Forarrangements that include more than one element, the Company allocates thetotal arrangement fee among each deliverable based on vendor-specific objectiveevidence (“VSOE”) of the relative fair value of each deliverable. VSOE isdetermined using the price charged when that element is sold separately by theCompany. Development and other revenues earned under courseware conversioncontracts are recognized relative to the Company’s proportionate performancebased on the ratio that total costs incurred to-date bear to total estimatedcosts. The Company uses direct labor hours as the key criteria to measureprogress towards completion. The Company develops its estimates to completebased on budgeted total costs and periodic assessment by Company projectmanagers. Provisions for losses on arrangements are made in the period in whichthey are determined.

The Company sometimes recognizes development and otherrevenues as a separate element of an arrangement with a customer that alsocontains an element to provide courseware delivery services. The SEC Staffbelieves that the best indicator that a separate element exists is that avendor sells or could readily sell that element unaccompanied by other elements.The Company has a history of selling courseware development and conversionservices unaccompanied by other elements. Further, EITF 00-21 (“*Revenue Arrangements with Multiple Deliverables”)*, statesthat a deliverable should be segmented and accounted for separately from theremainder of the arrangement if: (1) there is objective and reliableevidence of the fair value of the element and (2) the element does notaffect the quality of use or the value of the other elements and the elementcan be purchased from an unrelated vendor without effecting the quality of useor value of the other elements. The Company believes that the hourly ratescharged for development revenues are consistent and represent the fair value ofthese services.

In most cases, development projects are requestedafter delivery of online tuition services has begun (i.e. no development workwas considered when terms of the online tuition agreement were negotiated). TheCompany has demonstrated the ability for its developed and converted materialto be used in absence of its platform. In addition, customers can use othervendors to develop electronic course material or develop course materialinternally for use on its platform. Accordingly, the Company believes thatseparate recognition of development revenues for customers who have onlinetuition contracts is appropriate.

Prior to the third quarter of 2004, the Company hadalso been recognizing revenues for other services. Revenues for other serviceswere being recognized as the services were delivered.

The Company accounts for cash received from customersas prepayments for future services as deferred revenue. The Company recognizesrevenue associated with those cash receipts in accordance with the abovepolicies.

In 2003, three customersindividually accounted for approximately 36%, 18% and 15% of net revenues, andin 2004 the same three customers individually accounted for 27%, 25% and 21% ofnet revenues. In 2005, two customers individually accounted for 36% and 20% ofnet revenues.

*Stock-BasedCompensation*

Through the periods covered bythis report, the Company has applied the intrinsic-value-based method ofaccounting prescribed by Accounting Principles Board Opinion No. 25 (“APB25”), *Accounting for Stock Issued toEmployees,*and related interpretations including FASB InterpretationNo. 44 (“FIN 44”),*Accounting forCertain Transactions Involving Stock Compensation, an interpretation of APB 25*,issued in March 2000, to account for its fixed-plan stock options. Underthis method, compensation expense is recorded only if the current market priceof the underlying stock exceeded the exercise price on the date of the grant.Statement of Financial Accounting Standards No. 123 (“SFAS 123”), *Accounting for Stock-Based Compensation*,established accounting and disclosure requirements using a fair-value-basedmethod of accounting for stock-based employee compensation plans. As allowed bySFAS 123, for the periods covered by this report the Company has elected tocontinue to apply the intrinsic-value-based method of 

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accounting describedabove, and has adopted only the disclosure requirements of SFAS 123 as amendedby Statement of Financial Accounting Standards No. 148, *Accounting for Stock-Based Compensation—Transitionand Disclosure, Amendment of SFAS 123* (“SFAS 148”).

Stock options and warrants granted to non-employeesare accounted 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.

Thefollowing table illustrates the pro forma effect on net loss attributable tocommon stockholders (net loss) and pro forma net loss per common share as ifthe Company had applied the fair value recognition provisions of SFAS No. 123to stock-based compensation.

| ** **                                                                                                           | ** ** | **2003**   | ** **  | **2004**   | ** ** | **2005**   | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|------------|-------------|------------|------------|------------|------------|
| Pro forma net  loss:                                                                                                 |       |       |        |       |       |       |       |
| As reported                                                                                                          |       | $          | (6,185,877  | )          | $          | (6,579,416 | )          | $ | 5,880,639 |   |
| Add: Non cash stock compensation included in  reported net loss attributable to common stockholders             |       | 126,056    |        | 153,973    |       | 109,493    |       |
| Deduct: Total employee non cash stock compensation  expense determined under fair value based method for  all awards |       | (5,486,954 | )           | (3,212,044 | )          | (2,185,731 | )          |
| Pro forma net  loss                                                                                                  |       | $          | (11,546,775 | )          | $          | (9,637,487 | )          | $ | (7,956,877 | ) |
| Net loss per  common share:                                                                                          |       |       |        |       |       |       |       |
| Basic and diluted—as reported                                                                                   |       | $          | (1.81       | )          | $          | (0.97      | )          | $ | (0.63 | ) |
| Basic and  diluted—pro forma                                                                                    |       | $          | (3.37       | )          | $          | (1.42      | )          | $ | (0.86 | ) |

 

The effect of applying SFAS No. 123 on the proforma net loss as stated above is not necessarily representative of the effectson reported net loss for future years due to, among other things, the vestingperiod of the stock options and the fair value of additional options to begranted in the future years.

Thefair value of each option grant is estimated on the date of grant using theBlack-Scholes option-pricing fair value model with the followingassumptions:

| ** **                       | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Dividend yield                   |       | 0        | %          | 0        | %          | 0        | %          |
| Volatility                       |       | 126      | %          | 130      | %          | 132      | %          |
| Average risk-free  interest rate |       | 3.52     | %          | 3.87     | %          | 4.15     | %          |
| Expected term                    |       | 7 years  |       | 8 years  |       | 8 years  |       |

 

*Concentration ofCredit Risk*

Financial instruments that potentially subject theCompany to significant concentrations of credit risk consist principally ofcash and cash equivalents and accounts receivable. The Company deposits itscash with financial institutions that the Company considers to be of highcredit quality.

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.

Three customersindividually represented 25%, 21%, and 17% of accounts receivable at December 31,2004. Two customers individually represented 37% and 12% of accounts receivableat December 31, 2005.

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*FinancialInstruments*

The carrying value of theCompany’s financial instruments, including cash and cash equivalents, accountsreceivable, loans receivable, accounts payable, accrued expenses and deferredrevenues approximated their fair values based on the short-term maturities ofthese instruments.

*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 70% of the tuition feesreceived with respect to certain courses.

Royalties are classifiedas a cost of revenues and amounted to approximately $1,530,000, $1,198,000 and$1,342,000 during the years ended December 31, 2003, 2004 and 2005,respectively.

*Advertising Costs*

The Company expensesadvertising costs as incurred. Advertising costs amounted to approximately $0,$70,000 and $132,000 for the years ended December 31, 2003, 2004, and 2005respectively.

*Income Taxes*

The Company provides forincome taxes in accordance with the liability method. Under this method,deferred tax assets and liabilities are determined based on differences betweenfinancial reporting and tax bases of assets and liabilities and are measuredusing the enacted tax rates and laws that are expected to be in effect when thedifferences are expected to reverse. Because the realization of tax benefitsrelated to the Company’s net deferred tax asset is uncertain, a full valuationallowance of $28,624,000 has been provided against the net deferred tax asset.

*Net Loss Per Share*

The Company follows theprovisions of SFAS No. 128, *Earningsper Share* (“SFAS No. 128”) which requires the Company topresent basic and diluted earnings (or net loss) per share. Basic earnings (ornet loss) per share is based on the actual weighted-average sharesoutstanding and excludes any dilutive effects of shares issuable upon theexercise or conversion of outstanding options, warrants and convertiblesecurities. To calculate diluted earnings (or net loss) per share, the earnings(or net loss) is divided by a denominator which includes not only actual sharesof common stock outstanding, but also the additional shares of common stockissuable upon exercise or conversion of stock options, warrants, andconvertible preferred stock. For all years presented, shares of common stockissuable upon the exercise or conversion of stock options, warrants, andconvertible preferred stock have been excluded from diluted earnings per sharebecause their effect is anti-dilutive.

*Recent AccountingPronouncements*

In December 2004, FASB issued SFAS No. 123(revised 2004), “Share-Based Payment”, or SFAS 123(R), which is a revision ofSFAS No. 123 “Accounting for Stock-Based Compensation” (as amended) andsupersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”.Generally the approach in SFAS 123(R) is similar to the approachdescribed in SFAS No. 123. However, SFAS 123(R) requires allshare-based payments to employees, including grants of employee stock options,to be recognized in the income statement based on their fair values. Pro formadisclosure is no longer an alternative upon adopting SFAS 123(R).

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The Company adopted SFAS 123(R) on January 1,2006. SFAS 123(R) permits public companies to adopt its requirements usingone of two methods:

The “modified prospective” method in whichcompensation cost is recognized beginning with the effective date (a) basedon the requirements of SFAS 123(R) for all share-based payments grantedafter the effective date and (b) based on the requirements of SFAS 123(R) forall awards granted to employees prior to the effective date of SFAS 123(R) thatremain unvested on the effective date; or

The “modified retrospective” method which includes therequirements of the modified prospective method described above, but alsopermits entities to restate based on the amounts previously recognized underSFAS 123(R) for purposes of pro forma disclosures either (a) allprior periods presented or (b) prior interim periods of the year ofadoption.

The Company will implement SFAS 123(R) in thefirst quarter of 2006 and intends to use the “modified prospective method”. TheCompany believes the pro forma disclosures in note 2, “Summary of SignificantAccounting Policies,” of the consolidated financial statements under thesub-heading “Stock-Based Compensation” provides an appropriate short-termindicator of the level of expense that will be recognized in accordance withSFAS 123(R) for stock options granted prior to January 1, 2006 plusthe expense related to stock options granted during 2006. The expense for stockoptions granted during 2006 cannot be determined at this time due to theuncertainty of the Company’s stock price, the related Black-Scholes fair valueand the timing of future grants.

In June 2005, the FASB ratified EITF Issue No. 05-2,“The Meaning of ‘Conventional Convertible Debt Instrument’ in EITF Issue No. 00-19,‘Accounting for Derivative Financial Instruments Indexed to, and PotentiallySettled in a Company’s Own Stock’ ” (“EITF No. 05-2”), whichaddresses when a convertible debt instrument should be considered “conventional”for the purpose of applying the guidance in EITF No. 00-19. EITF No. 05-2also retained the exemption under EITF No. 00-19 for conventionalconvertible debt instruments and indicated that convertible preferred stockhaving a mandatory redemption date may qualify for the exemption provided underEITF No. 00-19 for conventional convertible debt if the instrument’seconomic characteristics are more similar to debt than equity. EITF No. 05-2is effective for new instruments entered into and instruments modified inperiods beginning after June 29, 2005. The Company has applied therequirements of EITF No. 05-2 since the required implementationdate.

In September 2005,the FASB ratified the following consensus reached in EITF Issue 05-8 (“IncomeTax Consequences of Issuing Convertible Debt with a Beneficial ConversionFeature”): a) the issuance of convertible debt with a beneficial conversionfeature results in a basis difference in applying FASB Statement of FinancialAccounting Standards SFAS No. 109, Accounting for Income Taxes.Recognition of such a feature effectively creates a debt instrument and aseparate equity instrument for book purposes, whereas the convertible debt istreated entirely as a debt instrument for income tax purposes. b) the resultingbasis difference should be deemed a temporary difference because it will resultin a taxable amount when the recorded amount of the liability is recovered orsettled. c) recognition of deferred taxes for the temporary difference shouldbe reported as an adjustment to additional paid-in capital. This consensus iseffective in the first interim or annual reporting period commencing after December 15,2005, with early application permitted. The effect of applying the consensusshould be accounted for retroactively to all debt instruments containing abeneficial conversion feature that are subject to EITF Issue 00-27, “Applicationof Issue No. 98-5 to Certain Convertible Debt Instruments” (and thusis applicable to debt instruments converted or extinguished in prior periodsbut which are still presented in the financial statements). The adoption ofthis pronouncement is not expected to have a material impact on the Company’sconsolidated financial statements.

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*Indebtedness withDetachable Warrants and Beneficial Conversion Feature*

The Company has accounted for the issuance ofdetachable stock purchase warrants in accordance with Accounting PrinciplesBoard Opinion 14 (“APB 14”), whereby the Company separately measured the fairvalue of the indebtedness and the detachable warrants and allocated the totalproceeds on a pro-rata basis to each. The proceeds allocated to the detachablewarrants are credited to paid-in capital and the discount from the face valueof the indebtedness is amortized over the estimated life of the indebtedness.

In accordance with theprovisions of Emerging Issues Task Force Issue 98-5 (“EITF 98-5”)and EITF 00-27, the Company allocated a portion of the proceeds receivedto the embedded beneficial conversion feature, based on the difference betweenthe effective conversion price of the proceeds allocated to the convertibleindebtedness and the fair value of the underlying common stock on the date theconvertible indebtedness was issued. Since the convertible indebtedness alsohad detachable stock purchase warrants, the Company first allocated theproceeds to the stock purchase warrants and the convertible indebtedness andthen allocates the resulting convertible indebtedness proceeds between thebeneficial conversion feature, which was accounted for as paid-in capital, andthe initial carrying amount of the convertible indebtedness. The discount resultingfrom the beneficial conversion feature is amortized over the estimated life ofthe convertible indebtedness.

*DerivativeFinancial Instruments*

The Company does not use derivative instruments tohedge exposures to cash flow, market, or foreign currency risks.

The Company reviews the terms of convertible debt andequity instruments issued to determine whether there are embedded derivativeinstruments, including the embedded conversion option, that are required to bebifurcated and accounted for separately as a derivative financial instrument.When the risks and rewards of any embedded derivative instrument are not “clearlyand closely” related to the risks and rewards of the host instrument, theembedded derivative instrument is generally required to be bifurcated andaccounted for separately. If the convertible instrument is debt, or hasdebt-like characteristics, the risks and rewards associated with the embeddedconversion option are not “clearly and closely” related to that debt hostinstrument. The conversion option has the risks and rewards associated with anequity instrument, not a debt instrument, because its value is related to thevalue of our common stock. Nonetheless, if the host instrument is considered tobe “conventional convertible debt” (or “conventional convertible preferredstock”), bifurcation of the embedded conversion option is generally notrequired. However, if the instrument is not considered to be conventionalconvertible debt (or conventional convertible preferred stock), bifurcation ofthe embedded conversion option may be required in certain circumstances.Generally, where the ability to physical or net-share settle the conversionoption is deemed to be not within the control of the Company, the embeddedconversion option is required to be bifurcated and accounted for as aderivative financial instrument liability.

In connection with the sale of convertible debt andequity instruments, the Company may also issue freestanding options orwarrants. Additionally, the Company may issue options or warrants tonon-employees in connection with consulting or other services they provide.Although the terms of the options and warrants may not provide for net-cashsettlement, in certain circumstances, physical or net-share settlement may be deemedto not be within the control of the Company and, accordingly, the Company maybe required to account for these freestanding options and warrants asderivative financial instrument liabilities, rather than as equity.

Derivative financial instruments are required to beinitially measured at their fair value. For derivative financial instrumentsthat shall be accounted for as liabilities, the derivative instrument isinitially recorded at its fair value and is then re-valued at each reportingdate, with changes in the fair value reported as charges or credits to income.

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In circumstances where the embedded conversion optionin a convertible instrument may be required to be bifurcated and there are alsoother embedded derivative instruments in the convertible instrument that arerequired to be bifurcated, the bifurcated derivative instruments are accountedfor as a single, compound derivative instrument.

If the embedded derivative instrument is to bebifurcated and accounted for as a liability, the total proceeds received willbe first allocated to the fair value of the bifurcated derivative instrument.If freestanding options or warrants were also issued and are to be accountedfor as derivative instrument liabilities (rather than as equity), the proceedsare next allocated to the fair value of those instruments. The remainingproceeds, if any, are then allocated to the convertible instrument itself,usually resulting in that instrument being recorded at a discount from its faceamount. In circumstances where a freestanding derivative instrument is to beaccounted for as an equity instrument, the proceeds are allocated between theconvertible instrument and the derivative equity instrument, based on theirrelative fair values.

To the extent that the fair values of the bifurcatedand/or freestanding derivative instrument liabilities exceed the total proceedsreceived, an immediate charge to income is required to be recognized, in orderto initially record the derivative instrument liabilities at their fair value.The discount from the face value of the convertible debt instrument is requiredto be amortized over the life of the instrument through periodic charges toincome, using the effective interest method. When the instrument is convertiblepreferred stock, the periodic amortization of the discount is charged directlyto retained earnings.

The Company reviews the classification of derivativeinstruments, including whether such instruments should be recorded asliabilities or as equity, at the end of each reporting period. Derivativeinstrument liabilities are required to be classified in the balance sheet ascurrent or non-current based on whether or not net-cash settlement of thederivative instrument could be required within 12 months of the balance sheetdate. The Company currently does not have any derivative instruments that arerequired to be bifurcated and recorded as liabilities.

*Registration RightsAgreements*

Inconnection with the sale of certain debt and equity instruments, the Companyhas entered into Registration Rights Agreements. Generally, these Agreementsrequire the Company to file registration statements with the Securities andExchange Commission to register common shares that may be issued on conversionof debt or preferred stock, to permit re-sale of common shares previously soldunder an exemption from registration or to register common shares that may beissued on exercise of outstanding options or warrants.

The Agreements usually require the Company to paypenalties for any time delay in filing the required registration statements, orin the registration statements becoming effective, beyond dates specified inthe Agreement. These penalties are usually expressed as a fixed percentage, permonth, of the original amount the Company received on issuance of the debt orpreferred stock, common shares, options or warrants. The Company accounts forthese penalties as a contingent liability and not as a derivative instrument.Accordingly, the Company recognizes the penalties when it becomes probable thatthey will be incurred. Any penalties are expensed over the period to which theyrelate.

*Segment Information*

The Company currently operates in one businesssegment; namely a provider of comprehensive outsourced e-Learning products andrelated services. The Company evaluates its market opportunities by referringto the Select Partner program business model and the Legacy business model. TheCompany is not organized by market and is managed and operated as one business.A single management team that reports to the chief operating decision makercomprehensively manages the entire business. The Company does not operate anymaterial separate lines of business or separate business entities with respectto its products or product development. Accordingly, the Company does notaccumulate discrete financial 

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information with respectto separate product lines and does not have separately reportable segments asdefined by SFAS No. 131, *“Disclosureabout Segments of an Enterprise and Related Information”.*

*Risks and Uncertainties*

The Company is subject to all of the risks inherent ina company that operates in the intensely competitive Internet industry,providing a service that is relatively new and constantly evolving. These risksinclude, but are not limited to**,**marketacceptance of the Company’s products and services, risks associated withacquisitions and expansion, and reliance on third-party software incorporatedin the Company’s products. The Company’s operating results may be materiallyaffected by these foregoing factors.

**3.**   Propertyand Equipment

Property and equipmentconsisted of the following:

| ** **                     | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **2004**              | ** ** | **2005** | ** ** |
| Equipment                      |       | $                     | 2,453,929  |   | $ | 2,518,702 |   |
| Computer software              |       | 1,295,173             |       | 1,311,325 |   |
| Leasehold  improvements        |       | 105,598               |       | 105,598 |   |
| Furniture and  fixtures        |       | 649,045               |       | 656,419 |   |
|                           |       | 4,503,745             |       | 4,592,044 |   |
| Less accumulated  depreciation |       | (3,980,083            | )          | (4,278,164 | ) |
| Total                          |       | $                     | 523,662    |   | $ | 313,880 |   |

 

**4.**   CapitalizedSoftware and Courseware Development Costs

Capitalizedsoftware and courseware development costs consisted of the following:

| ** **                                | ** ** | **December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|
| ** **                                | ** ** | **2004**              | ** ** | **2005** | ** ** |
| Capitalized  software costs               |       | $                     | 5,008,247  |   | $ | 5,008,247 |   |
| Capitalized  courseware development costs |       | 1,700,795             |       | 2,323,305 |   |
|                                      |       | 6,709,042             |       | 7,331,552 |   |
| Less accumulated  amortization            |       | (4,882,297            | )          | (6,022,975 | ) |
| Total                                     |       | $                     | 1,826,745  |   | $ | 1,308,577 |   |

 

**5.**   Goodwilland Other Intangible Assets

Otherintangible assets were comprised of:

| ** **                     | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **2004**              | ** ** | **2005** | ** ** |
| Developed content              |       | $                     | 523,800    |   | $ | 523,800 |   |
| Trademarks and  names          |       | 904,720               |       | 904,720 |   |
| Customer base                  |       | 304,820               |       | 304,820 |   |
|                           |       | 1,733,340             |       | 1,733,340 |   |
| Less accumulated  amortization |       | (1,342,838            | )          | (1,476,334 | ) |
|                           |       | $                     | 390,502    |   | $ | 257,006 |   |

 

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Amortizationexpense for other intangible assets is expected to be as follows:

| 2006   |   | 110,740 |    |
|--------|--------|---------|---------|
| 2007   |   | 66,078  |    |
| 2008   |   | 43,747  |    |
| 2009   |   | 36,441  |    |
|   |   | $       | 257,006 |   |
|        |        |         |         |  |

 

Amortization expenserelated to intangible assets subject to amortization totaled $178,998, $178,992and $133,496 for the years ended December 31, 2003, 2004 and 2005,respectively.

With the adoption of SFAS 142, amortization ofgoodwill was discontinued as of January 1, 2002.

**6.**   Restructuring ofOperations and Other Non-Recurring Items

In June 2003,the Company and the landlord at its Rockville, Maryland facility agreed to asettlement regarding the leased space that the Company vacated in December 2000.During 2003, the Company paid the landlord a total of $300,000 (plus a $24,000security deposit retained by the landlord) to terminate the lease agreement. Asa result of this settlement, the Company recorded an additional amount of$73,000,  which it included in restructuringand other non-recurring items on the 2003 statement of operations.

In June 2002, a former employee (separated in June 1998)filed suit against the Company in Dallas County, Texas. To avoid furtherlitigation expenses and the risk of an adverse ruling, in June 2003 theCompany paid the employee $99,999 in full settlement of all the claims,including the plaintiff’s attorneys’ fees.

**7.**   Loans Receivablefrom Related Party

Loans receivable from a Company officer are unsecuredand amounted to $49,783 and $15,453 as of December 31, 2004 and 2005,respectively. The Company accrues interest on the loans receivable at a rate ofprime less 1%. Interest income related to loans receivable amounted to $2,992,$2,038 and $1,670 during the years ended December 31, 2003, 2004 and 2005,respectively. The amount repaid on loans receivable from related parties was$36,000 in each of 2003, 2004 and 2005.

**8.**   NotesPayable

In December 2001and January 2002, the Company raised $925,000 through the issuance of 8%debentures together with five-year, fully vested warrants to purchase 132,143shares of common stock at $4.00 per share. The Company allocated the proceedsof the offering to the debentures and the warrants based on their relative fairvalues using the Black-Scholes option pricing model. The amount allocatedto the warrants ($335,841 and $40,708 for the 2001 and 2002 funding,respectively), was recorded as a debt discount and was amortized to interestexpense over the period the debentures were outstanding. In March 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 of 5,878 shares of Series F-2 Preferred Stockplus a warrant to purchase 5,878 shares of common stock at $4.00 per share, inexchange for the cancellation of a convertible promissory note in the principaland 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 31,2003 and 2004 was $0. Principal and accrued interest under the debentures wasdue and payable at December 31, 2003. The debentures were convertible intoshares of the Company’s common stock at the election of the holders at aconversion price 

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of $3.50 per share. In March 2004, the Companyrepaid the entire principal of $225,000 and accrued interest of  approximately $40,000 under the debentures.

In March 2004,the Company raised $5,000,000 in gross cash proceeds through the privateplacement of 20 units, at a purchase price of $200,000 per unit, and Series Bsenior secured convertible notes in the aggregate principal amount of$1,000,000. Each unit consisted of 50,000 shares of common stock (initiallypriced at $1.63 per share), a Series A senior secured convertible note inthe original principal amount of $118,500 and a five-year warrant topurchase 61,350 shares of common stock. The Company issued an additional$250,000 of Series B senior secured notes in exchange for cancellation ofexisting short-term indebtedness in that amount. The Company issued to the Series Bnoteholders five-year warrants to purchase an aggregate of 383,439 sharesof common stock. The exercise price for the warrants is $1.63 per share. Additionally,the Company issued one quarter unit to the lead investor’s counsel as paymentfor legal services. The Company allocated the proceeds from the issuance of thenotes to the notes and to that subset of warrants allocated to the notes basedon their relative fair values using the Black-Scholes option pricingmodel. The amount allocated to the warrants ($1,462,538) was recorded as a debtdiscount to be amortized to interest expense over the period the notes areexpected to be outstanding. The notes are convertible into shares of theCompany’s common stock at the election of the holders at a conversion price of$1.63 per share. Total shares of common stock issued in connection with thisprivate placement were 1,012,500. The fair value of the warrants allocated tothe common stock on a pro-rata basis has been accounted for as cost of capital.

Theterms of the financing include antidilution provisions to the effect that ifand whenever in the period commencing after the issuance date (March 23,2004) and ending 24 months thereafter (March 22, 2006) (the “AntidilutionPeriod”), the Company issues or sells, or is deemed to have issued or sold, anyshares of common stock, with the exception of specific customary issuanceswhich are excluded, for a consideration per share less than the conversionprice or exercise price in effect immediately prior to such time for therelevant shares, then concurrent with such dilutive issuance, the conversionprice or exercise price for the notes and warrants, as the case may be, then ineffect shall be reduced to an equal amount to the new securities issuanceprice.

Uponstockholder approval of the private placement in May 2004, the Companyrecorded an additional $2,187,087 of debt discount for the instrument’sbeneficial conversion feature. In addition, $18,500 of principal of each of the Series Anotes was converted into common stock at $1.63 per share and $100,000, or 50%,in principal of each of the Series B notes was converted into common stockat $1.63 per share. The total principal amount for both Series convertedupon approval of the stockholders was $999,625, resulting in the issuance of613,276 shares of common stock. The Company recorded a total of $2,650,000 ofthe placement as equity and $2,650,000 as senior debt. The notes mature on April 1,2009 and bear interest at the rate of 8% per annum payable quarterly in cash orstock (valued at the conversion price) at VCampus’ option for the first year. Principaland interest on the notes are payable in cash over the following four years inquarterly installments. The note holders have alleged an event of default hasoccurred under the notes. The Company plans to pursue negotiations with thenote holders in an effort to reach an amicable resolution to the matter (seenote 9).

During2004 and 2005, an additional $512,500 and $541,809 of Series A and Series Bsenior secured convertible note principal was converted into 314,420 and332,398 shares of common stock, respectively, resulting in $2,053,934 ofaggregate principal from this financing converted as of December 31, 2005.During 2005, the Company made its first two regularly scheduled principalpayments on the notes in cash in the aggregate amount of $210,301. The totaloutstanding principal remaining under these convertible notes as of December 31,2005 amounted to $1,385,390. The total unamortized debt discount associatedwith these notes as of December 31, 2005 amounted to $714,105, resultingin a net liabilities balance on the notes of $671,285, of which $191,796 isclassified as a current liability on the financial statements.

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Interestdue for the quarters ended June 30, September 30, December 31,2004 and March 31, 2005 amounted to $205,634 and was paid through theissuance of an aggregate of 126,142 shares of common stock valued at $1.63 pershare on July 1, 2004, October 1, 2004, January 1, 2005 andApril 1, 2005, respectively. Interest for the quarters ended June 30and September 30, 2005 amounted to $66,703 and was paid in cash onJuly 1 and October 1, 2005, respectively. Interest for the quarterended December 31, 2005 amounted to $27,708 and is included in accruedexpenses on the consolidated balance sheet.

As of December 31,2005, future maturities of long-term debt obligations were as follows:

| 2006   |   | 395,826 |      |
|--------|--------|---------|-----------|
| 2007   |   | 395,826 |      |
| 2008   |   | 395,826 |      |
| 2009   |   | 197,912 |      |
|   |   | $       | 1,385,390 |   |
|        |        |         |           |  |

 

**9.**   Commitments andContingencies

*Leases*

The Company leases office space and office equipmentunder non-cancelable operating lease agreements with various renewal options. Futureminimum lease payments may be periodically adjusted based on changes in thelessors’ operating charges. Rent expense for the years ended December 31,2003, 2004 and 2005 was $520,743, $520,710 and $521,959, respectively.

As of December 31,2005, payments due under non-cancelable operating leases were as follows:

| 2006       |   | 540,778 |      |
|------------|--------|---------|-----------|
| 2007       |   | 557,001 |      |
| 2008       |   | 573,711 |      |
| 2009       |   | 590,923 |      |
| Thereafter |   | 98,968  |      |
|       |   | $       | 2,361,381 |   |
|            |        |         |           |  |

 

*EmploymentAgreements*

The Company has enteredinto employment agreements with certain members of management. These agreementsspecify minimum annual salaries as well as objective-based and discretionaryperformance bonus amounts to be paid over the next year.

*Purchase Commitment*

In January 2005, theCompany and a vendor extended a reseller agreement they had initially enteredinto in 2000, for another year. Pursuant to this extension, the Company wasrequired to generate sales of the vendor’s courseware sufficient to generateroyalties of $150,000. To satisfy its obligations under the extension, theCompany paid the vendor $100,000 in cash in 2005 and was allowed to carry $50,000of the paid-for but unsatisfied portion of its prior year commitment to thisvendor into the twelve months ending January 30, 2006, which is the periodof the renewal. As of December 31, 2005, the Company had fully satisfiedthe $150,000 commitment for the twelve months ending January 30, 2006 andowed the vendor an additional $41,763, which is included in accrued expenses onthe consolidated balance sheet.

F-23

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*Alleged Default onSecured Convertible Notes*

*In February 2006,holders of a majority of the Company’s Series A and Series B securedconvertible notes notified VCampus that they believe an event of default existsunder the notes based on the Company’s failure to acknowledge their allegedright to have the conversion price on their notes reduced from $1.63 per shareto $0.50 per share, which is the lowest potential reset conversion price forthe Series A-1 Preferred Stock the Company issued to other investorsin the December 2005 financing. The Company disputes the claims made bythe note holders for a number of reasons, including the fact that theirantidilution rights expire, pursuant to the express terms of the notes andwarrants, prior to the price reset date on March 31, 2006, and hence theyexpire prior to the happening of the alleged event or contingency that mightotherwise trigger their rights. Consequently, the Company believes the noteholders’ allegations are without merit.*

*Litigation*

In June 2002, a former employee (separated in June 1998)filed suit against the Company in Dallas County, Texas. To avoid furtherlitigation expenses and the risk of an adverse ruling, in June 2003 theCompany paid the employee $99,999 in full settlement of all the claims,including the plaintiff’s attorneys’ fees.

In June 2003, the Company and the landlord at itsRockville, Maryland facility agreed to a settlement regarding the leased spacethat the Company had vacated in December 2000. The Company paid thelandlord a total of $300,000 (plus a $24,000 security deposit retained by thelandlord) to terminate the lease agreement. As of December 31, 2002 theCompany had accrued $253,051 for this liability on its consolidated balancesheet. As a result of this settlement, the Company recorded an additionalamount of $73,000 which it included in restructuring and other non-recurringitems on the 2003 statement of operations.

In 2002, the VirginiaDepartment of Taxation completed an audit of the Company’s sales and use taxpayments from August 1998 through October 2001. In July 2002,the Company received a draft assessment which contemplated a payment of taxes,penalties and interest by the Company of $212,719, primarily associated withthe Company’s alleged failure to assess use tax on third-party royaltiespaid by the Company to content providers for courses we delivered online. TheCompany paid the sales and use tax and interest on non-contested items, whichamounted to $18,928 out of the $212,719. The Company has formally contested theremaining items covered by the draft assessment, including the assessment ofuse tax on the royalties paid by the Company to content providers for coursesthe Company delivered online as well as the methodology used by the VirginiaDepartment of Taxation to estimate the royalties. In July 2003, theassessment was reduced by the Virginia Department of Taxation to $86,678including interest of $17,278. In October 2003, the Company appealed theassessment. In March 2004, the Company was notified that this appealremains under review. The Company does not have a firm estimate of theprobability of liability for this issue or the amount of anticipated legalcosts, but has reason to believe that the potential liability will be reducedto the point where it will not be considered material. Accordingly, the Companycannot estimate at this time the amount of liability to be incurred, if any. Noamounts have been accrued in the consolidated financial statements for thispotential liability.

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**10.**   Compositionof Certain Financial Statement Captions

Otherassets consisted of the following:

| ** **                    | ** ** | **December 31,** | ** ** |
|-------------------------------|------------|-----------------------|------------|
| ** **                    | ** ** | **2004**              | ** ** | **2005** | ** ** |
| Deferred debt  offering costs |       | $                     | 292,206    |   | $ | 149,924 |   |
| Other                         |       | 126,478               |       | 81,935 |   |
|                          |       | $                     | 418,684    |   | $ | 231,859 |   |

 

Accruedexpenses consisted of the following:

| ** **                         | ** ** | **December 31,** | ** ** |
|------------------------------------|------------|-----------------------|------------|
| ** **                         | ** ** | **2004**              | ** ** | **2005** | ** ** |
| Accrued payroll  and payroll taxes |       | $                     | 37,665     |   | $ | 123,215 |   |
| Accrued vacation                   |       | 27,952                |       | 35,965 |   |
| Deferred rent                      |       | 131,508               |       | 128,440 |   |
| Other                              |       | 121,353               |       | 191,696 |   |
|                               |       | $                     | 318,478    |   | $ | 479,316 |   |

 

Accrued payroll as of December 31,2004 and 2005 primarily consists of earned but unpaid incentive compensation.

**11.**   Stockholders’Equity

*Conversion ofPreferred Stock*

In June 2003,pursuant to approvals obtained at its annual meeting of stockholders, togetherwith agreements signed by holders of its preferred stock, the Company convertedall of the outstanding shares of each of its eight classes of preferred stockinto a total of 3,007,453 shares of common stock. The conversions wereeffective on June 6, 2003 at conversion prices ranging from $2.196 to$69.82 per share. This recapitalization removed a total of approximately $24.3million of preferred stock liquidation preference that was formerly senior tothe outstanding common stock and released the Company from the obligation topay future dividends on the converted shares. As an incentive to induce theconversions, the Company issued warrants to the preferred stockholders topurchase a total of 451,445 shares of common stock at $3.85 per share. TheCompany valued the warrants using the Black-Scholes option pricing model andrecognized a deemed dividend of $1,042,838, which represents the excess of thefair value of the warrants issued over the fair value of the stock issuablepursuant to the original conversion terms of the securities. As part of therecapitalization, the Company also issued a warrant to a preferred shareholderto purchase 166,155 shares of common stock at $2.20 per share in exchange forthe cancellation of that shareholder’s warrant to purchase an equivalent numberof shares of Series E preferred stock at the equivalent exercise price. TheCompany valued the warrants using the Black-Scholes option pricing model andrecognized a deemed dividend of $12,211 upon the cancellation of the warrantsto purchase shares of Series E preferred stock.

*Series CPreferred Stock*

In January 2003,11,817 shares of Series C Preferred Stock were converted into 1,433 sharesof common stock. In June 2003, the remaining 611,522 shares of Series CPreferred Stock were converted into 74,122 shares of common stock.

F-25

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*Series DPreferred Stock*

In June 2003,1,013,809 shares of Series D Preferred Stock were converted into 101,381shares of common stock.

*Series EPreferred 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”) in May 1999. Under the EquityLine Agreement, the Company had the right, subject to certain conditions, toissue 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 toavailability. The Company had the right to sell to H&QGF shares of its Series EPreferred Stock at a price equal to 85% of the lower of (1) the closingmarket price of the Company’s common stock on the date of issuance and (2) theaverage of the lowest intra-day prices of the Company’s common stock over thefive-day period ending on the date of issuance. Each ten shares of Series EPreferred Stock were convertible into one share of common stock. The holders ofSeries E Preferred Stock were entitled to monthly dividends paid in Series EPreferred Stock, equal to 0.5% of the number of shares of Series EPreferred Stock held. The value of Series E Preferred Stock issued asdividends amounted to $3,348 for 2003.

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 pershare (subsequently adjusted to 1,138,440 shares at $0.2196 per share pursuantto anti-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 thirdparty. In March 2000, the Company granted H&QGF fully vested warrantsto purchase 43,632 shares of Series E Preferred Stock at an exercise priceof $8.50 per share (subsequently adjusted to 384,960 shares at $0.2196 pershare pursuant to anti-dilution rights) in exchange for an increase in capacityand extension of the equity line. These warrants expire in November 2006.In October 2000, the Company granted H&QGF fully vested, seven-yearwarrants to purchase 15,000 shares of Series E Preferred Stock at anexercise price of $1.94 per share (subsequently adjusted to 132,350 shares at$0.2196 per share pursuant to anti-dilution rights) in exchange for a furtherincrease 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 PreferredStock at an average price of $2.26. During 2000, the Company drew down$4,382,000 under the Equity Line Agreement and issued 963,092 shares of Series EPreferred Stock at an average price of $4.55 per share. During 2001, theCompany drew down $213,150 under the Equity Line Agreement and issued 187,500shares of Series E Preferred Stock at an average price of $1.14 per share.During 2000 and 2001, 621,503 and 306,454 shares of Series E PreferredStock were converted into 62,150 and 30,645 common shares, respectively.

In February 2001, the Equity Line Agreement wasterminated. During 2001, the Company issued 60,000 shares of Series EPreferred Stock to H&QGF as consideration for the Company’s failure to keepan active registration statement effective in accordance with H&QGF’s registrationrights. In April 2001, the Company regained compliance with H&QGF’sregistration rights through the filing and effectiveness of a new registrationstatement.

In June 2003,the remaining 584,835 shares of Series E Preferred Stock were converted into58,484 shares of common stock. Additionally, the Company issued awarrant to H&QGF to purchase 166,155 shares of common stock at $2.20 pershare in exchange for the cancellation of H&QGF’s warrant to purchase anequivalent number of shares of Series E preferred stock at the equivalentexercise price.

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

In June 2003, the4,485,991 shares of Series F, F-1 and F-2 Preferred Stockoutstanding were converted into 1,150,144 shares of common stock.

*Series GPreferred Stock*

InFebruary 2003, the Company issued10,125 and 226 shares of Series G Preferred Stock at a purchase price of$39.50 per share to accredited investors and a placement agent,respectively. Under the terms of this financing, the Company also issued five-year fully vested warrants to purchase 25,313and 564 shares of common stock at $4.35 per share to the same accreditedinvestors and placement agent, respectively. Each share of Series G Preferred Stock was initiallyconvertible into 10 shares of common stock at any time at the election of theholder. The excess of the value of common stock into which theSeries G Preferred Stock was convertible over the proceeds allocated tothe Preferred Stock amounted to $48,995. Such amount represented a beneficialconversion feature discount and was immediately recognized as a deemed dividendto preferred stockholders. The fair value of the preferred stock was estimatedat the closing price of the Company’s common stock on the trading date prior tothe issuance date and the fair value of the warrants was estimated at $82,267using the Black-Scholes option pricing model.

InMarch 2003, the Company issued18,370 shares of Series G Preferred Stock at a purchase price of $27.22per share to accredited investors. Under the terms of this financing,the Company also issued five-year fullyvested warrants to purchase 45,925 shares of common stock at $2.99 per share tothe same accredited investors. Each share of Series G Preferred Stock was initially convertible into 10 sharesof common stock at any time at the election of the holder. The excess ofthe value of common stock into which the Series G Preferred Stock wasconvertible over the proceeds allocated to the Preferred Stock amounted to$198,312. Such amount represented a beneficial conversion feature discount andwas immediately recognized as a deemed dividend to preferred stockholders. Thefair value of the preferred stock was estimated at the closing price of theCompany’s common stock on the trading date prior to the issuance date and thefair value of the warrants was estimated at $129,967 using the Black-Scholesoption pricing model. The issuance of the Series G Preferred Stock inMarch 2003 triggered an antidilution adjustment in the conversion price ofthe Series G Preferred Stock issued in February 2003 from $3.95 to$2.72. As a result, the number of common shares potentially issuable uponconversion of the Series G Preferred Stock issued in February 2003increased from 103,527 to 150,229. The Company recorded a deemed dividend of$184,481 in connection with this adjustment.

In June 2003, the 78,041 shares of Series GPreferred Stock outstanding were converted into 873,022 shares of common stock.

*Series HPreferred Stock*

In May 2003, the Company issued 7,503 shares of Series H Preferred Stock at a purchase priceof $240.00 per share to accredited investors. Under the terms of thisfinancing, the Company also issued five-yearfully vested warrants to purchase 187,575 shares of common stock at $5.00 pershare to the same accredited investors. Each share of Series H Preferred Stock was initiallyconvertible into 100 shares of common stock at any time at the election of theholder. The excess of the value of common stock into which the Series HPreferred Stock was convertible over the proceeds allocated to the PreferredStock amounted to $776,862. Such amount represented a beneficial conversionfeature discount and was immediately recognized as a deemed dividend topreferred stockholders. The fair value of the preferred stock was estimated atthe closing price of the Company’s common stock on the trading date prior tothe issuance date and the fair value of the warrants was estimated at $455,807using the Black-Scholes option pricing model. The issuance of the Series HPreferred Stock in May 2003 triggered an antidilution adjustment in theconversion price of the Series G Preferred Stock issued in November 2002and in 

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February and March 2003from $2.49, $2.72 and $2.72, respectively, to $2.40. As a result, the number ofcommon shares potentially issuable upon conversion of the Series GPreferred Stock issued in those periods increased from 363,114 to 409,020. TheCompany recorded a deemed dividend of $124,676 in connection with thisadjustment.

In June 2003, the7,503 shares of Series H Preferred Stock outstanding were converted into 750,300shares of common stock.

*Series A-1Preferred Stock*

In December 2005, the Company issued 2,300 sharesof a newly created class of Series A-1 Preferred Stock at a purchaseprice of $1,000 per share to a group of accredited investors. The shares of Series A-1Preferred Stock are initially convertible into common stock at a conversionprice of $1.67 per share. The conversion price is subject to a price reset on March 31,2006 to equal $0.61 in the event that before March 31, 2006 the commonstock does not trade at or above $6.00 per share for at least ten consecutivetrading days after the shares of common stock issued or issuable in thefinancing have been registered for resale under a registration statementdeclared effective by the SEC. Under the terms of this financing, the Companyalso issued warrants to purchase 1,032,929 shares of common stock at anexercise price per share equal to the then applicable conversion price of the Series A-1Preferred Stock. The exercise price of the warrants is subject to adjustmentupon any change to the conversion price of the Series A-1 PreferredStock. The Series A-1 Preferred Stock and the related warrantsissued in this financing have price-based antidilution protection, but theCompany may not issue securities at a dilutive price that would trigger suchprotection unless and until shareholder approval is obtained for the financing.The Company intends to solicit shareholder approval for the financing at itsnext annual meeting of shareholders scheduled for May 2006.

The shares of Series A-1 Preferred Stockare entitled to receive quarterly cash dividends at an annual rate of 10% andare redeemable by VCampus, at any time after effectiveness of the registrationstatement, for 120% of the original purchase price. None of the Series A-1investors may hold more than 4.99% of VCampus’ outstanding shares of commonstock at any given time, subject to waiver of that limitation by the Series A-1investor upon 75 days’ notice.

The Company incurred a finder’s fee for the financingequal to 8.0% of the gross proceeds from covered investors payable in cash,plus a fee of 2.0% of proceeds from covered investors paid in shares of Series A-1Preferred Stock, together with a warrant, with the same terms as the investors,to purchase 75,450 shares of common stock.

The Company agreed toregister the resale of shares of its common stock issuable to the investors andfinders upon conversion of the preferred stock and exercise of the warrantsissued in the private placement.

*Common Stock*

In June 2003, pursuant to approvals obtained atits annual meeting of stockholders, together with agreements signed by holdersof its preferred stock, the Company converted all of the outstanding shares ofeach of its eight classes of preferred stock into a total of 3,007,453 sharesof common stock.

In September  2003, the Company raised $825,330through the private placement of 318,660 units, at a purchase price of $2.59per unit. In October  2003, the Company raised $200,000 through theprivate placement of 77,220 units, at a purchase price of $2.59 per unit. Eachunit consisted of one share of common stock and a three-year warrant topurchase one share of common stock with an exercise price of $2.59 per share.Aggregate proceeds from these private placements, net of $120,000 in financingcosts, amounted to $905,330. In connection with these financings, the Companypaid a placement agent a fee 

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equivalent to 7% of theamount raised, paid in units. Under the terms of the financing, because theCompany did not raise an additional $2,000,000 in equity financing by November 15,2003, on that date the unit holders became entitled to receive additionalshares of common stock as if the purchase price per share of common stock hadequaled $2.00 when the units were purchased, and the exercise price of thewarrants decreased to $2.00 per share. As this was a placement of common stock,the fair value of the warrants issued was accounted for as cost of capital.

During 2003, the Company issued 23,618 shares of itscommon stock, at an average price of $2.18 (equal to the fair market value ofthe stock on the date of each transaction) per share, to certain of itsdirectors in lieu of cash compensation for their services. The Company recorded$51,487 of compensation expense in connection with these issuances.

During 2003, the Company issued 12,041 shares ofits common stock at an average price of $2.49 (equal to the fair market valueof the stock of the date of each transaction) to a financial advisor as aretainer fee. The Company recorded an expense related to the stock issuance of$30,000.

In March 2004, the Company raised $5,000,000 ingross cash proceeds through the private placement of 20 units, at a purchaseprice of $200,000 per unit, and Series B senior secured convertible notesin the aggregate principal amount of $1,000,000. Each unit consisted of 50,000shares of common stock (initially priced at $1.63 per share), a Series Asenior secured convertible note in the original principal amount of $118,500and a five-year warrant to purchase 61,350 shares of common stock. TheCompany issued an additional $250,000 of Series B senior secured notes inexchange for cancellation of existing short-term indebtedness in that amount. TheCompany issued to the Series B noteholders five-year warrants topurchase an aggregate of 383,439 shares of common stock. The exercise price forthe warrants is $1.63 per share. Additionally, the Company issued one quarterunit to the lead investor’s counsel as payment for legal services. See thedisclosures in note 8, “Notes Payable” on page F-20 for furtherdetails of the March 2004 private placement.

During 2004 and 2005, the Company issued an additional314,420 and 332,398 shares of common stock upon the conversion of $512,500 and$541,809 of Series A and Series B senior secured convertible noteprincipal, respectively, resulting in $2,053,934 of aggregate principal fromthis financing converted as of December 31, 2005. During 2004 and 2005,the Company issued an additional 72,388 and 53,754 shares of common stock uponthe conversion of $117,992 and $87,642 of interest on the Series A and Series Bsecured convertible promissory notes, respectively.

In May 2004, the Company issued 76,688 shares ofcommon stock valued at $2.47 per share in full satisfaction of accruedfinancing costs of $189,419 incurred in conjunction with the March 2004financing.

During 2004, the Company issued 1,132,617 shares ofcommon stock upon the exercise of warrants and options with an average strikeprice of $1.76 per share. Net proceeds to the Company from these exercisesamounted to $1,944,283.

During 2004, the Company issued 17,112 shares of itscommon stock, at an average price of $2.01 (equal to the fair market value ofthe stock on the date of each transaction) per share, to certain of itsdirectors in lieu of cash compensation for their services. The Company recorded$34,474 of compensation expense in connection with these issuances.

During 2004, the Company issued 55,085 shares ofits common stock at an average price of $1.71 (equal to the fair market valueof the stock of the date of each transaction) to two financial advisors asretainer fees. The Company recorded an expense related to these stock issuancesof $94,000.

In March 2005, the Company completed a privateplacement of its common stock. Under the terms of this private placement, theCompany raised $995,950 in gross proceeds through the issuance of 611,012shares of common stock at a purchase price of $1.63 per share to 12 accreditedinvestors. Under the terms 

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of this financing, theCompany also issued five-year warrants to purchase 763,765 shares of commonstock with an exercise price of $1.63 per share to the same accreditedinvestors. In connection with this financing, the Company incurred a finder’sfee of approximately $50,000, paid in 30,550 shares of common stock. As thiswas a placement of common stock, the fair value of the warrants issued wasaccounted for as cost of capital.

During 2005, the Company issued 23,263 shares of itscommon stock, at an average price of $1.03 (equal to the fair market value ofthe stock on the date of each transaction) per share, to certain of itsdirectors in lieu of cash compensation for their services. The Company recorded$23,993 of compensation expense in connection with these issuances.

During 2005, theCompany issued 80,011 shares of its common stock at an average price of $1.39(equal to the fair market value of the stock of the date of each transaction)to two financial advisors as retainer fees. The Company recorded an expenserelated to these stock issuances of $111,000 of which $25,500 was recorded in2004 and $85,500 was recorded in 2005.

*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’sBoard of Directors decided not to grant any further options under the OriginalPlan.

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. Stock options under the Original Plan and 1996 Planare generally granted at prices which the Company’s Board of Directors believesapproximates the fair market value of its common stock at the date of grant. Individualgrants generally become exercisable ratably over a period of four to five yearsfrom the date of grant. The contractual terms of the options range from threeto ten years from the date of grant. The 1996 Plan expires in August 2006.

Commonstock option activity was as follows for the periods indicated:

| ** **                                | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                | ** ** | **2003**                                    | ** ** | **2004** | ** ** | **2005** | ** ** |
| ** **                                | ** ** | **Shares**                                  | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Outstanding at  the beginning of the Year |       | 299,865                                     |       |   | $ | 15.03 |   |   | 529,243 |   |   | $ | 7.50 |   |   | 1,414,047 |   |   | $ | 3.95 |   |   |
| Granted                                   |       | 307,469                                     |       |   | 2.50 |   |   | 1,129,544 |   |   | 1.94 |   |   | 1,240,020 |   |   | 0.96 |   |   |
| Exercised                                 |       | (35,659                                     | )          |   | 2.29 |   |   | (76,837 | ) |   | 2.26 |   |   | (75,770 | ) |   | 1.11 |   |   |
| Canceled or  expired                      |       | (42,432                                     | )          |   | 28.83 |   |   | (167,903 | ) |   | 2.38 |   |   | (176,755 | ) |   | 2.65 |   |   |
| Outstanding at  the end of the Year       |       | 529,243                                     |       |   | 7.50 |   |   | 1,414,047 |   |   | 3.95 |   |   | 2,401,542 |   |   | 2.59 |   |   |
| Options exercisable at  year-end          |       | 240,442                                     |       |   | $ | 11.99 |   |   | 259,756 |   |   | $ | 11.92 |   |   | 640,426 |   |   | $ | 5.94 |   |   |

 

As of December 31, 2005, 52,838 shares wereavailable for issuance under the 1996 Plan.

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The following tablesummarizes information about fixed-price stock options outstanding atDecember 31, 2005:

| ** **                                  | ** ** | **Options Outstanding**                             | ** ** | **Options Exercisable**              | ** ** |
|---------------------------------------------|------------|----------------------------------------------------------|------------|-------------------------------------------|------------|
| **Range of Exercise Prices** | ** ** | **Number  Outstanding at  December 31,  2005** | ** ** | **Average  Remaining  Contractual  Life** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Number  Exercisable at  December 31,  2005** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
| Less than $1.00                             |       |                                                     | 1,123,750  |                                      |       |   | 9.5 |   |   |   | $ | 0.95 |   |   |   | 10,000 |   |   |   | $ | 0.98 |   |   |
| $ 1.01 – $   2.00  |       |                                                     | 1,008,750  |                                      |       |   | 8.4 |   |   |   | 1.88 |   |   |   | 400,374 |   |   |   | 1.87 |   |   |
| $ 2.01 – $   3.00  |       |                                                     | 58,245     |                                      |       |   | 6.3 |   |   |   | 2.69 |   |   |   | 55,352 |   |   |   | 2.69 |   |   |
| $ 3.01 – $   5.00  |       |                                                     | 151,735    |                                      |       |   | 6.8 |   |   |   | 3.80 |   |   |   | 117,263 |   |   |   | 3.80 |   |   |
| $ 5.01 – $ 10.00             |       |                                                     | 9,000      |                                      |       |   | 5.0 |   |   |   | 7.31 |   |   |   | 8,500 |   |   |   | 7.22 |   |   |
| $10.01 – $ 20.00                  |       |                                                     | 15,327     |                                      |       |   | 5.0 |   |   |   | 13.31 |   |   |   | 15,327 |   |   |   | 13.31 |   |   |
| $20.01 – $180.00                       |       |                                                     | 34,735     |                                      |       |   | 3.4 |   |   |   | 64.22 |   |   |   | 33,610 |   |   |   | 65.01 |   |   |
|                                        |       |                                                     | 2,401,542  |                                      |       |   | 8.7 |   |   |   | $ | 2.58 |   |   |   | 640,426 |   |   |   | $ | 5.94 |   |   |

 

The weighted average fair values of the optionsgranted in 2003 with a stock price equal to the exercise price was $2.50. Theweighted average fair values of the options granted in 2004 with a stock priceequal to the exercise price was $1.94. The weighted average fair values of theoptions granted in 2005 with a stock price equal to the exercise price was$0.96.

*Warrants*

TheCompany has also granted warrants to purchase common stock to variousinvestors, employees and outside vendors. Warrant activity was as follows forthe periods indicated (in shares of common stock):

| ** **                                | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                | ** ** | **2003**                                    | ** ** | **2004** | ** ** | **2005** | ** ** |
| Outstanding at  the beginning of the year |       | 1,108,911                                   |       | 2,375,116 |   | 2,961,410 |   |
| Granted                                   |       | 1,924,159                                   |       | 3,751,560 |   | 1,872,144 |   |
| Exercised                                 |       | —                                      |       | (1,111,942 | ) | — |   |
| Canceled or  expired                      |       | (657,954                                    | )          | (2,053,324 | ) | (154,933 | ) |
| Outstanding at the end  of the year       |       | 2,375,116                                   |       | 2,961,410 |   | 4,678,621 |   |

 

Exercise prices on theoutstanding warrants range from $1.63 to $70.00 per share. The weighted averagegrant date fair value of warrants issued in 2005 was $1.65. The fair value ofeach warrant grant is estimated on the date of grant using the Black-Scholesoption-pricing fair value model with the following ranges of assumptions:dividend yield of 0%; expected volatility of 69% to 133%; risk-free interestrate of 4.39% to 6.50%; and expected life of the warrant term of three to sevenyears.

*Reserve forIssuance*

As of December 31,2005, the Company had reserved 7,080,163 shares of common stock for issuanceupon the exercise of outstanding options and warrants.

**12.**   Retirement Plans

The VCampus Corporation 401(k) plan (adopted in1997) 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 2003, 2004 and 2005, there were nodiscretionary Company contributions made to the plan.

F-31

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**13.**   Income Taxes

Incometax expense for the years ended December 31, 2003, 2004 and 2005 isdifferent from the amount computed by applying the statutory federal income taxrates to losses before income tax expense. The reconciliation of thesedifferences is as follows:

| ** **                                     | ** ** | **December 31** | ** ** |
|------------------------------------------------|------------|----------------------|------------|
| ** **                                     | ** ** | **2003**             | ** ** | **2004** | ** ** | **2005** | ** ** |
| Tax benefit at  federal statutory rate         |       | $                    | (1,108,000 | ) | $ | (2,303,000 | ) | $ | (2,010,000 | ) |
| State income  taxes, net of federal tax effect |       | (158,000             | )          | (329,000 | ) | (230,000 | ) |
| Increase in  valuation allowance               |       | 1,240,000            |       | 1,844,000 |   | 870,000 |   |
| Other                                          |       | 26,000               |       | 788,000 |   | 650,000 |   |
| Change in  effective tax rate                  |       | —               |       | — |   | 720,000 |   |
| Income tax expense                             |       | $                    | —     |   | $ | — |   | $ | — |   |

 

Deferredincome taxes reflect the net tax effects of temporary differences between thecarrying amounts of assets and liabilities for financial reporting and incometax purposes. The Company has recognized a full valuation allowance against thedeferred tax assets because the Company has determined that it is more likelythan not that sufficient taxable income will not be generated during thecarryforward period available under the tax law to utilize part or all of thedeferred tax assets. The valuation allowance for deferred taxes increased$1,240,000, $1,844,000 and $870,000 in the years ended December 31, 2003, 2004and 2005. Significant components of the Company’s net deferred tax assets wereas follows:

| ** **                        | ** ** | **December 31,** | ** ** |
|-----------------------------------|------------|-----------------------|------------|
| ** **                        | ** ** | **2004**              | ** ** | **2005** | ** ** |
| Net operating  loss carryforwards |       | $                     | 26,279,000 |   | $ | 27,160,000 |   |
| Accrued payroll                   |       | 35,000                |       | 13,000 |   |
| Other accruals                    |       | 53,000                |       | 50,000 |   |
| Other assets and  liabilities     |       | 1,387,000             |       | 1,401,000 |   |
| Total deferred  tax assets        |       | 25,754,000            |       | 28,624,000 |   |
| Valuation  allowance              |       | (27,754,000           | )          | (28,624,000 | ) |
| Net deferred tax assets           |       | $                     | —     |   | $ | — |   |

 

As of December 31,2004 and 2005, the Company had net operating loss carryforwards for federalincome tax purposes of approximately $65,000,000 and $69,700,000, respectively,which will expire at various dates through 2025. The Company may be deemed tohave experienced changes in ownership which may impose limitations on itsability to utilize net operating loss carryforwards under Section 382 ofthe Internal Revenue Code.

F-32

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**14.**   Net Loss Per Share

Thefollowing table sets forth the computation of basic and diluted net loss pershare:

| ** **                                                                        | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                        | ** ** | **2003**                                    | ** ** | **2004** | ** ** | **2005** | ** ** |
| Numerator:                                                                        |       |                                        |       |   |   |   |   |
| Net loss                                                                          |       | $                                           | (3,259,023 | ) | $ | (6,579,416 | ) | $ | (5,866,327 | ) |
| Less: Dividends  accruing to preferred stockholders                               |       | (2,926,854                                  | )          | — |   | (14,312 | ) |
| Net loss  available to common stockholders                                        |       | $                                           | (6,185,877 | ) | $ | (6,579,416 | ) | $ | (5,880,639 | ) |
| Denominator:                                                                      |       |                                        |       |   |   |   |   |
| Denominator for  basic earnings per share—weighted-average shares            |       | 3,423,056                                   |       | 6,792,321 |   | 9,266,800 |   |
| Denominator for diluted earnings per share—adjusted  weighted-average shares |       | 3,423,056                                   |       | 6,792,321 |   | 9,266,800 |   |
| Basic and diluted loss per share:                                                 |       |                                        |       |   |   |   |   |
| Net loss per share  available to common stockholders                              |       | $                                           | (1.81      | ) | $ | (0.97 | ) | $ | (0.63 | ) |

 

Thefollowing equity instruments (with underlying common share numbers shown in thetable) were not included in the diluted net loss per share calculation becausetheir effect would have been anti-dilutive:

| ** **                    | ** ** | **Year ended December 31,** | ** ** |
|-------------------------------|------------|--------------------------------------------|------------|
| ** **                    | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2005** | ** ** |
| Convertible notes  payable:   |       | 64,285                                     |       | 1,311,354 |   | 849,946 |   |
| Convertible  preferred stock: |       |                                       |       |   |   |   |   |
| Series A-1               |       | —                                     |       | — |   | 1,402,391 |   |
| Stock options                 |       | 529,243                                    |       | 1,414,047 |   | 2,401,542 |   |
| Warrants                      |       | 2,375,116                                  |       | 2,961,410 |   | 4,678,621 |   |

 

**15.**   Subsequent Events

In March 2006, theCompany completed a private placement of Series B-1 convertiblePreferred Stock. Under the terms of this financing, the Company raised$2,300,000 in gross proceeds through the issuance of 2,300 of Series B-1 convertible PreferredStock at a purchase price of $1,000 per share to two accredited investors.Under the terms of this financing, the Company also issued ten-year warrants topurchase 1,000,000 shares of common stock to the same accredited investors atan exercise price per share equal to the then applicable conversion price ofthe Series B-1 Preferred Stock. Thewarrants are first exercisable commencing four years from their issuance date. Beginningthree years from their date of issuance, the shares of Series B-1Preferred Stock are convertible, at the option of their holders, into commonstock based on a formula that yields a discount of between 10% and37.5% to the last closing bid price of the common stock priorto the date of conversion, subject to a price floor of $1.64 per share. Theshares of Series B-1 Preferred Stock are entitled toreceive dividends paid quarterly at the greater of:  (a) anannual rate of 16%, or (b) 6% of the net sales proceeds from two coursesto be mutually agreed upon by the parties. Each share of Series B-1Preferred Stock has a liquidation preference equal to 150% of the purchaseprice paid for the share. The shares of Series B-1Preferred Stock are non-voting. The Company intends to solicit shareholderapproval for the financing at its 2006 annual meeting scheduled for May 2006.

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**16.**   QuarterlySales and Earnings Data—Unaudited

Thefollowing table presents the quarterly results for VCampus Corporation and itssubsidiaries for the years ended December 31, 2004 and 2005

| ** **                                    | ** ** | **1**st Quarter | ** ** | **2nd Quarter** | ** ** | **3rd Quarter** | ** ** | **4th Quarter** | ** ** |
|-----------------------------------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|
| **2005**                                      |       |                 |       |                 |       |                 |       |                 |       |
| Revenue                                       |       | $                    | 1,128,582  |                 | $          | 1,093,089            |       | $                    | 1,244,612  |   | $ | 1,098,180 |   |
| Loss from  operations                         |       | (1,422,218           | )          | (1,230,238           | )          | (905,633             | )          | (1,152,843           | )          |
| Net loss  attributable to common stockholders |       | (1,902,673           | )          | (1,456,104           | )          | (1,212,427           | )          | (1,309,435           | )          |
| Net loss per share,  basic and diluted        |       | $                    | (0.22      | )                    | $          | (0.15                | )          | $                    | (0.13      | ) | $ | (0.14 | ) |
| **2004**                                      |       |                 |       |                 |       |                 |       |                 |       |
| Revenue                                       |       | $                    | 1,494,052  |                 | $          | 1,464,944            |       | $                    | 917,635    |   | $ | 987,228 |   |
| Loss from  operations                         |       | (762,493             | )          | (885,930             | )          | (1,321,648           | )          | (1,211,266           | )          |
| Net loss  attributable to common stockholders |       | (789,205             | )          | (2,297,861           | )          | (1,768,487           | )          | (1,723,863           | )          |
| Net loss per share,  basic and diluted        |       | $                    | (0.15      | )                    | $          | (0.34                | )          | $                    | (0.24      | ) | $ | (0.22 | ) |

 

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**SCHEDULE II—VALUATION AND QUALIFYING ACCOUNT ANDRESERVE(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,  2003 |       |       | $          | 31                                             |       |          |       | $              | 9          |                                         |       |   | $ | (35 | )(1) |   |   | $ | 5 |   |   |
| Year ended  December 31, 2004 |       |       | 5          |                                           |       |          | —     |           |       |                                         | —     |   |   |   | 5 |   |   |
| Year ended  December 31, 2005 |       |       | 5          |                                           |       |          | —     |           |       |                                         | —     |   |   |   | 5 |   |   |
|                                    |            |            |            |                                                |            |               |            |                |            |                                              |            |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Uncollectible amountswritten off. Net of recoveries.

F-35

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